The long-awaited change to the lease accounting standard ASU 2016-02, Leases (ASC 842) is now effective for privately-held companies. As the first major update to lease accounting in 40 years, the core principle of ASC 842 is that lessees will have to recognize a right-of-use (ROU) asset and a corresponding lease liability for almost all leasing arrangements, except those that are 12 months or less. Implementation presents a significant challenge for many technology companies, both large (who may have substantial operating lease obligations due to their sheer size) and small (who often rely on leasing due to budgeting or capital constraints). Smaller technology companies face additional challenges due to their limited back-office accounting and financial reporting resources. Fortunately, the previous implementation of the new lease standard by public companies provides an opportunity for private companies to understand how to prepare and understand the challenges encountered throughout the process. Here are five lessons learned that could help private technology companies.
1. Lease contracts are everywhere. Not every contract considered a lease under ASC 842 is labeled as such. A lease is a contract that conveys the right to control the use of a specified asset (e.g., hosted servers) during a period of time in exchange for consideration. Many technology companies lease space from data centers to host servers and related IT equipment. Additionally, subscription-based “as-a-service” arrangements (e.g., Software-as-a-Service, Hardware-as-a-Service, etc.) have grown exponentially in recent years. These arrangements may include multiple components, such as a lease of servers or other IT equipment. As such, a lease agreement can be embedded in other types of contracts, and considerable judgment is involved in determining whether an arrangement contains an embedded lease.
Finding these embedded leases can involve considerable time and effort, including closely examining all operations and agreements with outside service providers and identifying areas where embedded leases are likely to exist. A review of the activity in expense accounts (e.g., excluding lease and rental expenses) can help identify recurring expenses that could be related to embedded leases.
Lesson – Identifying a complete lease population is not just a matter of obtaining what are labeled as lease or rental agreements; it will require time, effort and judgment and involve resources outside the accounting and finance teams.
2. The required lease information can be challenging to obtain and extract. ASC 842 requires companies to identify critical information within lease agreements, including dates and lease payments. Some leases have numerous amendments, which can add complexity to finding the appropriate source document for the required information. Further, some of the required information, including discount rates, the expected term of an evergreen month-to-month lease and the probability of executing purchase or renewal options, are subject to significant management judgment and estimation.
Lesson – Don’t underestimate the time necessary to collect and organize lease data; it is not right there at your fingertips.
3. Manual processes are less practical for maintaining source documentation, producing journal entries and preparing financial statement disclosures. ASC 842 requires significantly more information and calculations to generate the appropriate journal entries and financial statement disclosures. As a result, many public companies procured software solutions or modified their existing systems to implement the standard successfully. These software solutions often took longer than expected to become fully operational.
Lesson – Depending on the volume of your leases, a manual process may not be the way to go. If you determine that a software solution is in your best interest, you should ensure that the solution has the measurement and disclosure reporting functionality your company needs and get started right away.
4. Determining the incremental borrowing rate (IBR) can be complex. You may need to consider a variety of IBRs for different lease terms and types. There is an alternative for private companies; instead of an IBR, they may use a risk-free rate by asset class (e.g., real estate, vehicles, IT equipment, etc.). However, given the current levels of risk-free rates, using such a rate could result in a higher lease liability and adversely impact debt covenant calculations.
Lesson – Don’t just assume that you can use any rate on your existing debt as the IBR. The IBR is a significant estimate in your lease calculations, and consideration needs to be given to the collateralization of the debt, term and nature of the lease and entity-specific factors that could impact the determination of your IBR.
5. Be prepared for surprises. Nearly every company runs into unexpected challenges once they get into implementation, including but not limited to embedded leases, the number of leases they actually have and the consideration of month-to-month and verbal agreements.
Lesson – Don’t assume that implementation will just be a matter of inputting the lease information you already have. It can be complex and most likely take longer than expected, so there is no time to wait.
Given that the new standard is went into effect for private companies January 1, 2022, we encourage you to act soon. If you have any questions on implementing and maintaining compliance with ASC 842 for your company, Moore Colson can help. Contact us for more information.