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Lease Accounting for Broker Dealers


By Charles Pagano, Bonnie Mann Falk and Jason Gutman

Broker dealers get ready!  ASC 842 will significantly impact most broker dealers’ financial statements and disclosures.  If you haven’t started the required analysis by ASC 842, there is no time like the present!

The Financial Accounting Standards Board’s (FASB) long-anticipated update to lease accounting, Accounting Standards Update No. 2016-02, Leases (Topic 842) (ASC 842), is effective after December 15, 2018; fiscal years and interim periods within those fiscal years.

The required transition disclosures included in the 2018 financial statements need to reflect the effect on the company’s financial reporting with execution beginning in the January 2019 FOCUS report.

While the implementation will require broker dealers to analyze their leases and recognize potentially material assets and liabilities on the financial statements and increase related disclosures, there is good news in that generally the effect on net capital and aggregate indebtedness should be minimal.

What are the Major Impacts?

Lessees need classify their leases as either finance or operating; each classification has its own unique accounting treatment. Finance leases cover arrangements that transfer control of assets at the end of their term, include purchase options, cover most of an asset’s useful life, or involve highly specialized assets.  These leases previously required to be recorded on the financial statements.

Conversely, operating leases do not transfer ownership at the end of the lease, do not include purchase options, have a lease term as part of the economic life, and do not have assets specialized to the use of the lessee.

The Implementation Guidance of the standard (ASC 842-10-55-1) includes a decision tree to assist in the classification.  In the broker dealer world, much of leasing transactions expect to be classified as operating leases.

Under the existing guidance, lessees recognize the expense of an operating lease ratably over its life. This “straight line” approach results in a more consistent bottom line. Moving forward, in addition to reporting a straight-line lease expense in their financial results, lessees will need to recognize an asset and a corresponding liability on their balance sheet. One of the most significant sources of lessees’ off-balance sheet financing and risk is now front and center in their financial statements, no longer solely delegated to a footnote disclosure.

Initially, the balance sheet is grossed-up to reflect a liability equal to the present value of the lease payments with a corresponding asset, now known as the “right of use” (ROU) asset. This results from a contract that conveys the right to control an “identified asset” for a period of time in exchange for consideration.

Most commonly, in the broker dealer industry, the new standard calls for recording assets and liabilities related to the following leases for the use of:

  • Office rent
  • Trading, communication and information systems equipment
  • Offsite document storage
  • Software solutions for case management, billing, and compliance

One is mindful of whether a lease or service contract exists when analyzing the transaction. ASC 842 could affect those situations where expense sharing or an administrative service agreement exists.

When determining the payments to be included in measuring the ROU assets and lease liabilities, one must consider all optional payments related to the lease.  Payments to be made during an option period would be included only if the lessee is reasonably certain to exercise an option to extend or not to terminate a lease.

Optional payments to purchase the assets at the end of the lease would be included only if the lessee is reasonably certain to exercise that purchase option.  Options to extend or not to terminate that are controlled by the lessor need to be considered as well.

Keep in mind, the nature of lease payments impacts the broker dealer’s balance sheet. Variable lease payments are not included in the measurement of a lease liability and ROU, since this liability is not fixed. Common examples of variable lease payments include rental increases based on CPI or inflation rate.

In both examples, the tenant’s initial base rent may be the only payment which, in substance, is fixed. These variable payments can increase or decrease over time and cannot be estimated.   Broker dealers may seek to negotiate greater variable terms in their lease payment structure to take advantage of this accounting treatment.

What About Non-Lease Components?

Many lease arrangements cover services provided by the landlord, such as janitorial, common area maintenance, or onsite IT support. These typically meet the definition of a “non-lease component,” since they do not grant the lessee control over an asset.

Lessees must assign a value to non-lease components based on their relative standalone prices or apply a practical expedient electing to account for the lease and non-lease components as a single liability. Performing an allocation may be time consuming, but applying the practical expedient may result in a significantly greater balance sheet obligation and related asset.

Typical Example

Let’s take a typical situation in a broker dealer with an operating lease scenario.  Assume the broker dealer rents office space for a three-year period with total lease payments over 36 months of $ 36,000 with lease payments of $10,000, $12,000 and $14,000 for each year respectively.  Assume a present value (“PV”) factor of 4.24% and no lease escalations.

The lease payments and present values of the payments are as follows:

As payments are made the lease liability is decreased as follows:

Each year the periodic lease expense is recognized using the average lease payment over the life of the lease.  The difference between the lease payment and the lease expense is recorded to adjust the ROU asset.  See the table and journal entries as follows:

The financial statement impact over the lease term is as follows:

What About Disclosures?

ASC 842 brings about new disclosures related to leases in order to provide users of the financial statement appropriate information to assess the amount, timing, and uncertainty of cash flows arising from leases.  Amongst the highlights of the quantitative and qualitative information to be disclosed include, but are not limited to:

  • The Company’s leases
    • A general description of the leases
    • Basis, terms, and conditions on which carriable lease payments are determined
    • Existence, terms, and conditions of all options to extend or terminate a lease (whether or not they are recognized as part of the ROU asset or lease liability) and any residual value guarantees provided by the leases
    • Any restriction or covenants imposed by leases
    • Leases between related parties
    • Relevant information on short term leases
  • Significant assumptions and judgements made, including but not limited to:
    • Determination if a contract contains a lease
    • Allocation of consideration in a contract between lease components and nonlease components and the detail of any election of using a practical expedient
    • Determination of the discount rate for the lease
  • Amounts recognized in the financial statements relating to those leases
    • Operating lease cost
    • Short-term lease cost, excluding expenses relating to leases with a lease term of one month or less
    • Variable lease cost
    • Amounts segregated between those for finance and operating leases for the following:
      • Cash paid for amounts included in the lease liabilities
      • Supplemental noncash information on lease liabilities arising from obtaining right-of-use assets
      • Weighted-average remaining lease term (see the implementation guidance)
      • Weighted-average discount rate (see the implementation guidance)
    • Five year and beyond annual undiscounted cash flow maturity analysis of its finance lease and operating lease liabilities separately, including a reconciliation of the to the lease liabilities recognized in the balance sheet.

SEC No Action Letter of October 23, 2018

The SEC recognized the possible disastrous results on net capital and addressed the effect of ASC 842 two years ago.  In a letter to SIFMA, from the SEC on October 23, 2018, the SEC rescinded a previously issued letter dated November 8, 2016.  Both letters granted relief to broker dealers whereby an operating lease asset is added back to net capital to the extent of the associated operating lease liability.

Additionally, the Division per the “No Action” letter “will not recommend enforcement action, if a broker-dealer determining its minimum net capital requirement using the AI (aggregate indebtedness method) does not include in its aggregate indebtedness an operating lease liability to the extent of the associated operating lease asset.”  The SEC went on to comment that each lease stands on its own; that is, one cannot offset an operating lease asset on one lease with an operating lease liability of another lease.

Also remember that the amount of the asset may reflect additional costs such as direct initial costs, prepaid lease payments and lease incentives which will cause the asset to not equal the liability.

What are the Steps to Implementation?

  • Gather and catalog your current inventory of leases, store lease data in a centralized repository.
  • Design and implement a new lease accounting process to manage your organization’s lease data.
  • Select a software solution that will support your organization’s adoption of the new lease accounting standards, and ongoing lease monitoring and maintenance. In the case of minimal leases Microsoft Excel may suffice.
  • Compute the amount of the asset and liability and be ready to book for those with calendar years beginning on January 1, 2019.
  • Fully train staff on new software solution, design and implement internal controls.
  • Determine the effect on net capital, if any.

Conclusion

With year-end fast approaching now is the time to assess the effects of ASC 842.  Companies need to be ready for 2018 transition disclosures and January reporting for your FOCUS filings.  You want to implement processes and establish internal controls to capture the necessary data in your books and records and for disclosure in the notes to the financial statements.

The standards include comprehensive guidance to assist companies in applying the requirements of ASC 842.  Once an entity completes its analyses, communication between the auditor and management ensures a smooth transition to a successful implementation.

 


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