New Lease Accounting Standard – Taking a Cue from Adoption by Public Companies

ASC Topic 842 is the culmination of a decade-long, joint project with the FASB’s international counterpart, the International Accounting Standards Board (IASB). The IASB released its standard on lease accounting, IFRS 16, Leases, on January 12, 2016. As the standard was being drafted, it sent shock waves through the accounting profession because of its potential significant impact on companies’ financial statements. The new standard requires lessees to recognize a right-of-use asset and a corresponding liability on the financial statements for almost all of their leases. Not only does the adoption requires companies to allocate resources to evaluate its existing leases and their accounting, it also has significant impact on companies with loan covenants. Immediately, CPAs received questions from Controllers and CFOs ranging from evaluation of existing leases, its implementation, the technical accounting calculation of the right-of-use asset and corresponding liability, how to structure future leases to ease adoption, and guidance on having a dialogue with bankers on the potential impact on covenant compliance.

Public companies have already adopted the standard effective January 1, 2019 and we have seen quite a diversity of lease structures and their impact on the financial statements. Private companies have another year to prepare for the adoption on January 1, 2020. Let’s take a look at what we learned.

Transition Methods

Companies can elect to apply the new lease accounting standard in one of two ways:

Method A – applied retroactively to each prior reporting period presented in the financial statements with a cumulative-effect adjustment recognized as the beginning of the earliest period presented; or

Method B – applied retrospectively to the beginning of the period of adoption through a cumulative-effect adjustment recognized as of the beginning of that period.

As you can imagine, given the difficulty in retrospectively applying the standard, even on a modified retrospective basis, most companies chose Method B.

Practical Expedients

As expected, most companies also elected certain practical expedients when applying the standard in order to gain efficiency. These practical expedients must be chosen as a package, and they allow companies to not reassess the prior conclusions under the old lease accounting standard regarding the followings:

  1. Whether a pre-existing contract is or contains a lease

2. Whether a pre-existing lease should be classified as an operating or finance lease

3. Whether the initial direct costs capitalized for a pre-existing lease under the old standard qualify for capitalization

It is important to note the these practical expedients cannot be used by companies to grandfather errors in the application of the old standard.

Hindsight Practical Expedient

Companies are allowed to make an election to use hindsight when determining lease term and impairment of the right-of-use asset. This practical expedient may be elected separately or in conjunction with the package of practical expedients mentioned above. Companies must apply the hindsight practical expedient to all pre-existing leases or apply it to none of them. If companies elect this practical expedient, they should consider all facts and circumstances that have changed through the adoption date. If companies do not elect this practical expedient, they should determine the lease term and impairment of the right-of-use asset based on facts and circumstances in existence when those determinations were otherwise made.

Electing this practical expedient could lead to a change in lease term, which may or may not be a desirable outcome. This may require more effort in initially measuring the lease liability and the right-of-use asset than if the lease term does not change or when not electing the hindsight practical expedient. Companies should carefully consider the effects of electing this practical expedient by determining whether those effects are worth the additional effort.

Land Easement Practical Expedient

A land easement is also known as a right of way that provides the lessee with the right to use, access or cross another entity’s land for a specified purpose. When companies elect the land easement practical expedient, they are allowed to not assess whether pre-existing or expired land easements that were not previously accounted for as leases under the old standard are or contain a lease under new standard. Only those pre-existing or expired land easements entered into on or after the adoption date are considered. The land easement practical expedient may be elected separately or in conjunction with either or both the package of practical expedients and (or) the hindsight practical expedient. Companies must apply the land easement practical expedient to all preexisting land easements or apply it to none of them.

We saw that most companies elected the land easement practical expedient because they have not typically identified land easements as leases in the past and the difficulties that would arise in assessing whether pre-existing or expired land easements are or contain a lease under the old standard.

Related Party Leases

The new lease accounting standard requires companies to account for related party leases on the basis of legally enforceable terms and conditions of the lease. This means that off-market terms should not be adjusted when determining the proper accounting for the transaction but the detail of the related party transaction would need to be disclosed.

Companies should also look beyond the stated terms of the lease and consider all facts and circumstances when evaluating related party leases and the initial measurement of the right-of-use asset and its corresponding liability. Companies may find themselves having to estimate future cash flows when measuring the initial right-of-use asset and the corresponding liability. Companies also should use judgement in determining lease term and consider asset and entity specific factors when evaluating related party leases under the new standard.

Disclosure

Don’t underestimate the effort required to comply with the disclosure requirements in the new standard. The new standard spells out the required qualitative and quantitative information that needs to be disclosed but doesn’t offer much guidance in terms of the manner of its presentation. As a result, we are seeing a diverse practice in how companies present the required information.

Qualitative information required to be disclosed includes, but not limited to, description of the lease, information about leases that have not commenced but have significant rights and obligations for the companies, information about significant judgements and assumptions made in accounting for the lease, and whether an accounting policy was made for short-term lease exemption.

Quantitative information required to be disclosed include, but not limited to, lease expense for finance and operating leases, right-of-use assets obtained in exchange for lease liabilities for finance and operating leases; weighted average remaining lease term for finance and operating leases; weighted average discount rate for finance and operating leases, etc.

Adopting any new accounting standard shouldn’t take away resources from companies from carrying out their most important mission – growing and making an impact in their communities. We can help you navigate through the new accounting standard by helping you evaluate whether this standard applies to you, and if so, determining lease classification, how to treat non-lease components, determine lease term and other variables that go into the initial measurement of the right-of-use asset and its corresponding liability, how to handle lease modifications, lease incentives, related party leases and provide the necessary information required to be disclosed. Keep Calm and Contact Us.

Accounting Implications of Tax Reform

The GOP Tax Reform was signed into law on December 22, 2017. While tax reform provides opportunities for tax planning, it also has significant impacts on companies’ financial statements. Since the regulation was signed into law in 2017, current accounting standards require that the impact from the changes in tax laws be reported in the period it was enacted. Companies are required to use reasonable efforts to account for the impact from the new law. However, given the scope and the timing of these changes, companies may not have all the necessary information to meet the current requirements. The SEC has issued Staff Accounting Bulletin No. 118 (SAB 118) to provide public companies with more guidance. The FASB also stated that it would not object to private companies and not-for-profit entities applying SAB 118 and they would be in compliance with GAAP. The FASB staff believes, however, that if these entities apply SAB 118, they should apply all relevant aspects of the SAB in its entirety.

Here are some of the changes that could have significant impact on companies’ financial statements.

Reduction in Corporate Income Tax Rate

The most significant change in this tax return package is the reduction of corporate income tax rate from 35% to 21%. Current accounting standards require companies value their deferred tax assets and liabilities using the enacted income tax rate. This would require companies to re-measure their 2017 deferred tax items using the new tax rate and the re-measurement will be part of income tax expense in continuing operations.

Fully Expense of Qualified Property

Companies placing qualified property in service between 9/27/17 and 12/31/22 can expense fully the cost of the assets. This will increase companies deferred tax liabilities due to accelerated depreciation expense under tax reporting.

Changes in Net Operating Loss Utilization

Previously, NOL can be carried back 2 years and carried forward 20 years. New rules state that NOL carry back is no longer allowed but it can be carried forward indefinitely. Companies with deferred tax asset may need to reassess whether a valuation allowance is necessary. In addition, new rules also limit the utilization of NOL to 80% of taxable income. As such, companies will owe tax in profitable years and will need to record a tax payable on the 20% of taxable income that cannot be offset by carrying forward NOL.

Limit on Interest Expense Deduction

Interest expense deduction will be limited to 30% of tax EBITDA through 2021. Any non-deductible interest expense can be carried forward indefinitely and therefore will generate a deferred tax asset. Companies will need to determine the likelihood of utilizing the deferred tax asset and whether a valuation allowance is necessary.

Entertainment Expense Deduction

Previously, entertainment expense was treated as 50% deductible, much like business meal expense. However, new rules prohibit deduction of entertainment expense all together. Companies should consider tracking entertainment expense separately from business meal expense on their books. The new rules do not change the deductibility of business meal expense which remains at 50%.

If you have questions as to how these changes may impact your companies’ financial statements, CFO Connections can help. You may contact us at stella@cfoconnections.com.

Hurricanes Related Accounting and Report Issues

Hurricanes Related Accounting and Report Issues

Four different hurricanes have made a U.S. landfall in 2017. This is the first time as many as four hurricanes have made a U.S. landfall since 2005.Hurricane Nate was the fourth hurricane to landfall in the United States in 2017, the first time that’s happened in a single hurricane season in over a decade. Nate made landfall around 7 p.m. CDT Oct. 7 near the mouth of the Mississippi River as a Category 1 hurricane, then made its final landfall near Biloxi, Mississippi, just after midnight Oct. 8. Hurricane Maria made landfall with winds of 155 mph on September 20 in Puerto Rico. In the weeks before Maria, hurricanes Harvey and Irma made landfall at Category 4 intensity with 130 mph winds on August 25 in Rockport, Texas, and September 10 in the Florida Keys, respectively.

Source:https://weather.com/storms/hurricane/news/2017-10-07-four-us-hurricane-landfalls-nate-maria-irma-harvey

Estimates for the cost of Hurricane Harvey’s damage have come in at $65 billion, $180 billion, and as high as $190 billion — the last of which would make it the costliest disaster in US history. The numbers from the second record-breaking storm that hit the US this summer, Hurricane Irma, meanwhile, are still rolling in. But totals range from $50 billion to $100 billion.

Source:https://www.vox.com/explainers/2017/9/18/16314440/disasters-are-getting-more-expensive-harvey-irma-insurance-climate

Here are some of the accounting and financial reporting implications of these events.

Financial Statement Reporting and Disclosure Considerations

Companies that incurred losses may need to expand its footnote disclosure to discuss circumstances surrounding the losses, any insurance claims made and any expected insurance reimbursements. Any uncertainties related to the claims should also be disclosed. These considerations are especially important for publicly traded companies since the SEC has in the past asked registrants to expand disclosure to discuss the effect of natural disasters on their operations quantitatively and qualitatively, such as loss of a major supplier or customer.

Assets Impairment Considerations

Were assets damaged or destroyed as a result of the hurricanes? The most commonly affected assets after a natural disaster are fixed assets, inventories and accounts receivable. Writing off these assets may be necessary if they are destroyed.

How about the projected cash flows from certain assets? Are they negatively affected? Companies should consider writing down assets that were damaged and revisit their estimated useful lives.

Loans and Banking Considerations

Financial institutions, especially those that have a substantial amount of loans in the affected areas, should consider the need to increase their allowance for loan losses. In the immediate aftermath of Hurricanes Harvey and Irma, a number of financial institutions waived late fees and extended payment deadlines to their customers. Therefore, special considerations should be given to disclosing loss of revenues.

On the other hand, companies may need additional financing or amend the terms of their existing credit agreements with banks to increase its borrowing capacity. Companies should evaluate whether the amendments represent modification of existing debts, or extinguishment of the existing debts and commencement of new arrangements.

As a result of the negative impact the hurricanes had on companies’ operations, companies may be in violation of their loan covenants – assets as collaterals destroyed or financial covenants not in compliance. This may trigger default and affect the classification of the debt on the balance sheet.

Accounts Receivable and Revenue Recognition

Companies that do businesses with those in the affected areas should consider collectability, write offs or reserve against the receivables. Companies that allow extended payment terms to the affected businesses should consider its effect on revenue recognition (Topic 606) since revenue can only be recognized when collection is probable.

Idle Capacity

Companies may experience below normal production level as a result of power interruption or fuel shortage. When assets are temporarily idle, depreciation should continue. On the contrary, depreciation should discontinue when assets are permanently unproductive.

Insurance

To properly manage the risk losses from natural disasters, companies have insurance policies to cover property, casualty and business interruption claims. When companies believe that reimbursement from insurance is probable, the companies should recognize a receivable for the amount expected to be recovered. However, the amount recorded cannot be greater than the recorded losses. If companies expect to be reimbursed for an amount greater than its recorded losses, the different should be treated as a gain contingency, i.e. recognized only when realized.

For companies that filed claims under their business interruption policies, they would also follow the accounting for gain contingency, i.e. recognized only when realized.

The classification of insurance proceeds in the income statement depends on the nature of the claims. Proceeds should be recorded in the income statement once the gain contingency is resolved. There are not guidance provided for many different types of claims and therefore judgement should be applied.

Insurance proceeds should be presented in the statement of cash flows based on the nature of the item insured. If the proceeds are for damaged fixed assets, it would be an investing cash flow. If the proceeds are for business interruption, it would be an operating cash flow.

Tax Considerations

Since profitability is negatively affected, companies should evaluate whether deferred tax assets are “more likely than not” that they would be realized and whether a valuation allowance is necessary.

Revenue Recognition 5 Steps Model – steps 3 to 5

The new revenue recognition model is a 5 steps model that guides companies in determining the amount and the timing of when revenues should be recorded. It shifts from the existing risk and reward model to one that emphasizes control. Here are the 5 steps:

  1. Identify the contract with the customer
  2. Identify the performance obligation, i.e. the goods and services to be provided to the customer
  3. Determine the transaction price
  4. Allocate the contract value to the goods and services to be provided
  5. Recognize revenues as goods and services are delivered to the customer

Last month’s newsletter provided you some insights on steps 1 and 2 and now, we’ll take a look at steps 3 to 5.

  1. Determine the transaction price

The transaction price is the amount the entity expects to be entitled to in exchange for its goods and services. Transaction price may include:

  • Variable consideration – this could be explicit or implicit and could include bonus, price concessions, refunds, milestone payments, discounts, returns, and rebates. The entity estimates the amount of the consideration it expects to be entitled to and that it is probable that a significant reversal of revenue recognized will not occur.
  • Returns or refunds – entity must estimate the amount of returns or refunds and reduce transaction price and record a refund liability.
  • Significant financing component – this represents consideration where the entity receives in advance or in deferred payment terms. Advance payment is likened to receiving a loan from the customer and results in recognition of interest expense and increase in transaction price whereas deferred payment is likened to financing the transaction for the customer and results in recognition of interest income and reduction in transaction price. There are several exceptions to reflecting the significant financing component. (1) the customer has discretion in the timing of the transferred goods and services, e.g. gift card sales; (2) payment of the variable consideration is contingent upon an uncertainty that the entity does not control, e.g. milestone payment contingent on regulatory approval; (3) when the difference in timing of payment and performance is not due to financing but for protection to the entity or customer from the other party for not fulfilling its obligations, e.g. construction contracts; (4) when the timing of payment and transfer of goods and services is one year or less.
  • Noncash consideration – its fair value should be included in transaction price. If the fair value of the noncash consideration changes after the contract inception, e.g. value of the customer’s stock, do not adjust the transaction price. If the change is other than in the form of the consideration, e.g. entity’s performance or scope modification, then account for it as a variable consideration.
  • Fixed cash consideration – this could include upfront nonrefundable fees that the entity would recognize revenue as goods and services are transferred to its customer.
  • Consideration payable to customer – it reduces transaction price unless the entity receives distinct goods and services from the customer
  1. Allocate the contract value to the goods and services to be provided

The entity will use a relative standalone selling price model to allocate the transaction price. It will estimate the standalone selling price for each performance obligation, determine if any discount or variable consideration should be allocated to one or more performance obligations and allocate the transaction price.

  1. Recognize revenues as goods and services are delivered to the customer

The transaction price allocated to a performance obligation is recognized as revenue when the performance obligation is satisfied, i.e. when the customer has the ability to direct the use of the goods or services and receives substantially all of the remaining benefits.

When is it effective?

Effective date for public entities is the first interim period within annual reporting periods beginning after December 15, 2017, i.e. 2018 for public companies with December 31 year end; nonpublic entities have an additional year. It also allows early adoption as early as 2017 calendar year.

Revenue Recognition 5 Steps Model – Steps 1 and 2

The new revenue recognition model is a 5 steps model that guides companies in determining the amount and the timing of when revenues should be recorded. It shifts from the existing risk and reward model to one that emphasizes control. Here are the 5 steps:

  1. Identify the contract with the customer
  2. Identify the performance obligation, i.e. the goods and services to be provided to the customer
  3. Determine the transaction price
  4. Allocate the contract value to the goods and services to be provided
  5. Recognize revenues as goods and services are delivered to the customer

In this month’s newsletter, we’ll take a look at the first two steps and then steps 3 to 5 next month.

  1. Identify the contract with the customer

A contract is defined as an agreement between two or more parties that create legally enforceable rights and obligations. It can be written, oral or implied based on customary business practices. If a contract provides for each party to terminate the agreement without penalty, then there is no accounting consequences related to the contract since there is not a legally enforceable right and obligation to the parties. However, just because there are legally enforceable rights and obligations, it doesn’t mean that you are in the clear. There are still some criteria that need to be evaluated to determine whether a contract exists.

  1. Does the contract have commercial substance?
  2. Have approvals been obtained and commitment to perform exist for both parties?
  3. Are rights of both parties are identifiable?
  4. Are payment terms identifiable? And
  5. Is collection probable?

Once these criteria are met, reassessment is not necessary unless signification changes in circumstances occur.

What if an entity goes through step 1 and determines that a contract does not exist? In this situation, any considerations received should be recognized as a liability and the entity should reassess the criteria each reporting period. If the criteria continue not to be met, the entity can only recognize revenues when the considerations received are nonrefundable and

  1. There are no remaining performance obligations and substantially all amounts have been received.
  2. The contract has been terminated. Or
  3. The entity has transferred the control of goods and services to which the nonrefundable considerations relate and the entity has no future obligation to transfer additional goods and services.

The last criterion differs from current guidance in that it allows for recognition of revenue in the amount related to the goods and services transferred even though the entity continues to perform under the contract.

Contract modifications – The guidance on contract modifications is new in comparison with existing guidance, except in contract accounting. The accounting for contract modifications allows for prospective treatment, a cumulative catch up adjustment or account for as a separate contract, depending on facts and circumstances. Some of the issues to consider include whether the changes are approved; the pricings of the modifications; any distinct new products or services added, etc.

  1. Identify the performance obligation, i.e. the goods and services to be provided to the customer

The overall objective of step 2 is to identify the units of account to which the entity will then apply steps 3 to 5 to. The entity will identify all of the promised goods and services, considering both explicit and implicit promises, based on customary business practices.

Next, the entity needs to consider whether the identified goods and services are distinct. If so, they are accounted for separately as a performance obligation, i.e. unit of account. Otherwise, the entity should combine other goods and services until there is a group that is distinct. The guidance does provide an exception that when goods or services are part of a series of distinct goods or services that are substantially the same, the series of goods or services is the performance obligation. A good example of this is television/cable services – the customers typically are locked into a contract and each hour of the service provided is distinct. However, since each hour of the service is substantially the same and is delivered in the same manner, they are counted as one performance obligation.

Since distinctiveness is a key factor, how does an entity determine whether a good or service is distinct? A good or service is capable of being distinct when a customer can benefit from it on its own or together from other readily available resources. For example, an entity sells equipment to its customers. The customers can sell the equipment on a standalone basis. The customers can use the equipment together with other goods or services that have already been transferred by the entity, i.e. installation service for equipment purchased by the customers; or installation services from other providers in the marketplace.

The entity should also consider whether warranty is a distinct performance obligation. If the customer has the option to purchase the warranty separately, then the warranty is a performance obligation. Otherwise, the entity should allocate part of the purchase price to the warranty and recognize revenues over time.

In addition, if the customer has the option to purchase additional goods and services, the option is a performance obligation for accounting purposes if it provides material right to the customers that the customers would not otherwise have without entering into the contract.

When is it effective?

Effective date for public entities is the first interim period within annual reporting periods beginning after December 15, 2017, i.e. 2018 for public companies with December 31 year end; nonpublic entities have an additional year. It also allows early adoption as early as 2017 calendar year.

Revenue Recognition Standard (Topic 606)

Revenue Recognition Standard (Topic 606)

What is it all about?

The new revenue recognition standard applies to contracts with customers except for those within the scope of other standards, e.g. leases, insurance, etc. The new standard eliminates the lack of consistency in revenue recognition across industries. Therefore, it improves comparability and eliminating gaps in guidance.

The new revenue recognition model is a 5 steps model that guides companies in determining the amount and the timing of when revenues should be recorded. It shifts from the existing risk and reward model to one that emphasizes control. Here are the 5 steps:

  1. Identify the contract with the customer
  2. Identify the performance obligation, i.e. the goods and services to be provided to the customer
  3. Determine the transaction price
  4. Allocate the contract value to the goods and services to be provided
  5. Recognize revenues as goods and services are delivered to the customer

The new revenue recognition standard also requires a lot of quantitative, as well as qualitative, information to be disclosed.

When is it effective?

Effective date for public entities is the first interim period within annual reporting periods beginning after December 15, 2017, i.e. 2018 for public companies with December 31 year end; nonpublic entities have an additional year. It also allows early adoption as early as 2017 calendar year.

How is it done?

Companies can select one of the two adoption methods – full retrospective or modified retrospective.

Full retrospective – this requires recasting prior years’ revenues as if the standard has existed from the beginning, i.e. the years shown prior to 2018. This method provides great comparability from period to period which is appealing to investors and analysts and other users of the financial statements but requires more efforts and resources for dual reporting.

Modified retrospective – no recasting is required but companies need to record the cumulative effects of the adoption to beginning retained earnings at the time of adoption. This may seem easier than the full retrospective approach but it also requires more disclosures to improve comparability in a different way.

Why should companies care?

Assessment – Companies should perform assessments to evaluate what kind of an impact this standard will have on their financial statements, if any.  Since the new standard’s issuance in 2014, companies that began their assessments reported that the process of assessment was taking longer than they thought. Even companies that didn’t believe that this new standard applied to them still should carry out such assessment to document that it has no impact on them. A lot of these companies found that once they began assessing the impact, the new standard actually have material impacts to them than originally thought.

Implementation – Significant amount of work that needs to be done during the implementation process in order to adopt the standard. Some companies discovered that they will need to change their processes and systems in order to be able to capture the data needed. Some discovered that they will need to involve personnel outside of accounting, e.g. operations, IT, sales, etc. in understanding their contracts with their customers. Some may decide that they will need to create sub-ledger in order to capture the data in their accounting systems.

Reporting – Much like the new lease accounting standard we discussed in our blog in May, this new revenue recognition standard could also have significant impact on certain financial covenants.

Although the 5 steps model may seem easy, the devil is in the details!! We can help you go through the model step by step and identify provisions that really matter when it comes to revenue recognition. Contact us at:

E-mail: Stella@cfoconnections.com

Phone: 813-508-5846

New Lease Accounting Standard – Why Should You Care?

New Lease Accounting Standard – Why Should You Care?

This new lease accounting standard was issued right around the same time the new revenue recognition standard was issued; it is another accounting change that will demand a tremendous amount of effort from companies to implement both standards within a relatively short period of time of each other.

You said, another standard for leases – what’s the big deal? Here is why you should care.

  1. Current GAAP provides bright line guidance around leases whereas the new lease standard moves to a more principle based approach and requires companies to make certain judgments that they haven’t previously made before. This is going to change how companies think about their leases, processes and controls.
  2. Since the new lease accounting standard calls for virtually all leases to go on the balance sheet, there is going to be an increased need for data, as supposed to the current standard where only lease commitments are required to be disclosed. This accounting change will prompt companies to evaluate their processes in order to ensure that they have identified all relevant data they will need to put the leases on the balance sheet.
  3. The new lease accounting standard is effective for calendar year 2019. For public and closely-held companies that present comparative financial statements, the standard should be applied to the earliest period presented.

Lease accounting standard – it’ll be here before you know it! We can help take the stress off your team by evaluating your current processes and helping you gather the data and implementing the standard with plenty of time to spare. Contact us at:

E-mail: Stella@cfoconnections.com

Phone: 813-508-5846