The new leases standard requires a modified retrospective transition approach. What does that entail? Watch PwC’s Marc Jerusalem as he describes the basic transition model, and the powerful package of practical expedients designed to make transition easier.
Hi, I’m Marc Jerusalem, a Director in PwC's national office.
Now that most companies have implemented the Revenue standard, they are focusing more attention on the new leases standard, effective in 2019 for public companies.
Given how quickly this date is approaching, today we will highlight the general transition approach for both lessors and lessees.
There are number of transition related practical expedients to consider when adopting the standard, but today I want to mention just the first one:
The “package” of practical expedients.
This refers to three expedients that must be adopted together. They are:
This is a really impactful expedient, especially not having to reassess lease classification!
But, say a company wants to reassess classification of a large lease, or they want to reexamine whether a specific arrangement contains a lease; can it do so?
Well, it could, but it would have to reassess all its leases – both as a lessee and as a lessor. This helpful package of expedients is, truly, all-or-nothing.
Practically speaking, we expect that most lessees and lessors will elect this package of expedients.
So, at the date of initial application, a lessee should record operating lease liabilities and right-of-use assets, since they’re not currently on its balance sheet.
A lessee's existing capital leases, however, as well as all lessor’s leases, are currently recorded on their balance sheets, so, as you might expect, transitioning those leases are easier.
Lessees electing this package simply carry forward their existing capital lease balances.
Similarly, lessors who elect this package of expedients literally just carry forward their lease related balances without adjustment.
So for both lessees and lessor there's no reassessing.
You can see why we think most companies would want to elect this package.
However, lessees must record lease liabilities and right-of-use assets for nearly every existing operating lease, even those with less than a year remaining in their lease term – if the lease term was originally longer than a year.
So, how does one measure the liability for operating leases?
The standard refers to the transition approach as a "modified retrospective approach."
As the name implies, this approach is not prospective – existing leases must come onto the balance sheet – but not quite retroactive either; it's a hybrid approach.
A company would measure lease liabilities by discounting the future minimum lease payments, as defined by the 0ld lease standard and amounts that a lessee will probably pay under a residual value guarantee.
To do so, a company would need to identify all of its leases, and, if those leases have renewal or cancellation options, the company would need to know the lease term it was using to account for those leases before adoption.
However, instead of using the interest rates that existed at lease inception, it discounts the payments using a new rate determined at the initial application date.
Now let's turn to the leased asset.
At the application date, the asset is measured as the same amount as the lease liability, adjusted for related assets and liabilities that the lessee had recorded on its balance sheet immediately prior to application.
These typically include unamortized balances of lease incentives and initial direct costs, as well as straight line rent accruals or prepaids.
As with most things, the transition isn’t quite as simple as it appears, and there will likely be other issues to consider.
For example, it will be important to know the length of lease terms, and to identify all leases, including those embedded in other contracts.
So, don’t wait. There's a lot of work to do to be ready to adopt the standard in 2019.