Are you ready for the new lease standards?
By Roman Scheller & Nowayrah Sadiq
Before the new leasing standards, critics argued that off the balance sheet liabilities reduce transparency and comparability for investors and encourage suboptimal capital allocation and decision-making by management.
Sir David Tweedie, the previous chairman of the International Accounting Standard Board, famously once said, “One of my great ambitions, before I die, is to fly in an aircraft that is on an airline’s balance sheet.”
The goal of the new rules was straightforward. “It puts things in a more transparent condition,” FASB vice chairman James Kroeker told the Wall Street Journal in 2016.
Another key driver for the change was that lease accounting principles under previous standards were not consistent. With an operating lease, even though there was a present obligation no different to that of a finance/ capital lease, yet no liability was recognized.
After a nearly 10-year collaboration, the Financial Accounting Standards Board (FASB) and International Financial Reporting Standard Board (IFRS) developed a converged standard on leasing. In 2016, the IASB issued IFRS 16, Leases, replacing IAS 17. Now all leases, minus a few exceptions, need to be reported on the balance sheet. IFRS 16 removes the lease classification model between operating and finance as all lessee leases are accounted for the same way. In the same year FASB issued Accounting Standards Update (ASU) 2016-02, Leases—Topic 842.4 ASC 840 is replaced by ASC 842 and unlike IFRS 16 keeps the lease classification, however, decides to copy IFRS and now calls a capital lease a finance lease. The difference to ASC 840 is that all operating leases need to be reported on the balance sheet.
The new lease accounting standards are expected to provide investors and other stakeholders with a more transparent view of a company’s financial picture. But for companies, the projected effort to prepare for these changes will be significant. Research conducted by Deloitte suggested “the standard will have far-reaching implications in areas such as accounting, finance and reporting, real estate, tax and technology, among others.”
Here’s a look at some key issues surrounding the new lease accounting standard.
Magnitude of the exercise
Lease identification is a prominent exercise under the new standard. The first step is to identify the population of leases that exist throughout the organization. To understand the magnitude of the data gathering exercise, one must understand that most companies not only lease office space but most of their basic assets, such as computers, printers, office furniture, IT systems, vehicles, heavy equipment, and warehouse space. A reporting entity must go through lengthy legal documents as part of implementing the new standard.
Lack of a centralised data base
Many companies especially with global operations do not have centralized database of their leases. Several years ago, accounting firm PwC noted that lease information was highly decentralized at 39 percent of the companies it surveyed.6 Organizations will require tremendous amounts of data to construct a database on what they own, what they lease, amounts they pay, who they pay and more. The data will serve as a foundation for conducting a thorough and technical assessment of leases. For companies that are the results of years of mergers or operate in multiple countries, the necessary data might not all reside at the same place. Compiling the data, tracking down all leases, in foreign languages and some dating back a few years will not be an easy feat. Depending on the organization, these efforts may entail a significant amount of up-front time and effort.
Identification of a lease
Given that the definition of a lease has changed under the new lease standards, organizations will have to take a deeper look at their leases and potential leases to understand the true exposure. Some agreements previously not viewed as leases might, in fact, now be classified as leases. Previously making a distinction between an operating lease and a service had limited impact, because the accounting treatment was similar. Now, the distinction becomes important, as leases are to be recorded as “right-of-use assets” and liabilities on the balance sheet whereas service contracts continue to be recorded “off balance sheet,” as they have been in the past. Further, parts of a contract can meet the definition of lease. Leases could be buried within seemingly non-lease transactions such as product or service arrangements and are therefore more difficult to identify.
Determining discount rates
The new lease accounting standards requires lessees and lessors to discount future lease payments using the rate implicit in the lease. A lessee, however, may use its incremental borrowing rate if the rate implicit in the lease cannot be readily determined. Determining a lessee’s incremental borrowing rate can be challenging. It will generally vary between leases having different terms and payment amounts and is the rate a lessee would pay on funds borrowed on a collateralized basis.
Managing the leases and lease accounting
Many companies use excel spreadsheets to construct and consolidate their lease data. At first glance, this may be a seem like a convenient way to manage and organise leases but the continuous need for updates maintenance, integration and audit trail doesn’t make it an effective solution in the long term. Companies will have to invest in new technology solutions that can capture relevant lease data, integrate it with business processes, and bring forward accurate and actionable lease-related information for balance sheet reporting.
It is worth noting that Internal resources are often stretched on other critical IT projects, and the finance and accounting departments often do not have the necessary resources and skills to deploy a new system. Although accounting software can automate the process, the initial data gathering effort and technical assessment will remain, irrespective of whether a system is deployed.
With many software’s and platforms available in the market, it can be challenging to select the right system or platform for your organisation’s needs. Companies need to look at the system as a whole and in the context of their overall requirements to see its impact not only on accounting but how well it integrated across the system landscape. I Impact to business processes, upstream and downstream reconciliations as well as reporting capabilities drive the potential for increased efficiency and cost-saving opportunities.
Educating the users and stakeholders
Given the technical and data-intensive challenge of preparing for the standard change, many companies may realize that they will have to enhance their accounting teams by increasing headcount or outsourcing to third parties. Further, the effects of the new standard may very well extend beyond the accounting department., Impacts to Tax, Treasury, Procurement and potentially Operations are expected, increasing the level of interaction with other departments involved in lease activities. Because so many stakeholders across the enterprise will be affected, companies need to plan and educate the stakeholders about the standard change.
The new lease accounting standard is poised to impose significant and possibly unforeseen transition challenges. That’s why it’s important to start planning right away. The deadline is real and looming. You need to start now if you haven’t started already. It could take up to a year to complete a transition to the new standards. You will require time to develop a plan and execute it. It’s important not to underestimate the amount of work and time the transition will take.
Maintenance of leases and considerations
The lease accounting implementation is not a one-off exercise, but an ongoing one. For example, right-of-use-assets must be assessed for impairment. Modifications made to a contract may result in previously off-balance-sheet items needing to be moved onto the balance sheet. Further, companies will have to remain cautious about how to tailor their contracts. They will need to look closely and think about the ongoing processes and controls to identify any missed lease or potential leases. The change, therefore, will have ripple effects far beyond balance sheet accounting, both in upstream and downstream processes.
Leases standards may have changed but tax rules have not and companies will need to assess possible tax implications.
The new lease accounting standards also might have an impact on all ratios involving assets and liabilities, particularly debt ratios. Given on balance sheet accounting following the new lease standard, companies need to re-examine their debt agreements with banks.
The way forward
Effectively adopting the new lease accounting standard will require discipline, insights, and in-depth guidance.
Recent surveys show that despite the significant effort, approaching deadlines and risk of non-compliance with accounting standards, many companies are still early in the adoption process, are only somewhat or completely unprepared.
Where are you in your implementation? Are you already compliant with the new standard, but are looking to optimize your existing solution? Are you struggling with some of the challenges in the adoption process or have not yet started? Our global team of consultants has experience assisting clients through all phases of lease (accounting) solutions, and are here to help.
KWA Analytics was founded in 2013. From our global offices based in Europe, the Americas, India, and Asia-Pacific, we offer a comprehensive range of Consulting Services, delivered by the most experienced and well-regarded consultants in the industry.
At KWA we believe in delivering the highest quality solutions to our clients, regardless of short-term profits or vested interests. Our commitment to client fulfilment is core to our company values.
Reach out to us at firstname.lastname@example.org, or use the button below to fill out our contact form.