Why the New Lease Accounting Standards Pose Major Challenges

Until recently, most companies didn’t have to pay much attention to leases when issuing financial statements. With the new lease accounting standards, that’s set to change – drastically. Companies will be required to record all of their leases on balance sheet. According to The Wall Street Journal, balance sheets may increase by as much as $2 trillion.

Transitioning to the new standards is a monumental task. Nearly 40% of public companies have found assessing and implementing the new standards to be more difficult than they expected, according to a 2018 PwC survey. To ensure they comply by the deadline (January 1, 2019 for calendar-year public companies; January 1, 2020 for calendar-year private), companies need to put this project at the top of their to-do list.

 

The impacts of failing to comply

The fact is, many companies aren’t ready to comply. Whether they’re bogged down with day-to-day accounting work, have budget and resource restrictions, or don’t truly understand ASC 842 and IFRS 16, they’re putting their compliance at risk.

Failing to comply can have wide-ranging implications – varying from material misstatements to sinking stock prices:

  • Job loss and damaged reputations for senior leaders
  • Loss of investor confidence
  • Scrutiny from the SEC
  • High auditing bills
  • Costly, time-consuming restatements

It’s critical that companies push back against the hurdles in their way to ensure they comply. Regulators have made it clear that they will crack down on those who don’t, because it sends the message that they don’t care about developing transparent financial statements.

 

Why the boards updated the standards – it’s all about transparency

After the financial scandals of the early 2000s, regulators and legislators issued numerous regulations and laws to reduce corporate fraud. However, lease obligations remained opaque. During The Great Recession, several firms with major leasing liabilities went bankrupt, despite their balance sheets being clean. Leases are a liability, but with the majority of them being off balance sheet, there is no way for investors to get a total picture of a company’s obligations.

Currently, leases are categorized as capital or operating leases. While the assets and liabilities related to capital leases are recognized on financial statements, operating lease payments are recognized as expenses over the lease term and have limited balance sheet impact.

The Financial Accounting Standards Board (FASB) worked in conjunction with the International Accounting Standards Board (IASB) to develop the new standards to provide more transparency about all leases.

As a result, FASB released Accounting Standards Codification (ASC) 842 and IASB released International Financial Reporting Standard (IFRS) 16.

 

How ASC 842 and IFRS 16 will improve financial reporting:

  • Offers fewer opportunities for organizations to manipulate lease transactions for a particular outcome
  • Provides a more comprehensive overview of lessees’ financial statements
  • Aligns lessor accounting and sale/leaseback transactions guidelines with the comparable 2014 revenue recognition standard
  • Exposes lessors’ credit and asset risk as a result of leasing
  • Clarifies the definition of a lease as it pertains to practice issues within current GAAP
  • Eliminates the need for investors and stakeholders to adjust the recognized amounts on financial statements to compensate for the lack of visibility into operating leases

Regulation timeline

Because of the complexity required to develop the new regulations, 10 years passed from the time that the boards announced their intention to update the standards to the date they were released. 

 

 

What’s changed

As stated above, there is currently a clear distinction with how lessees record operating leases and capital leases. Operating leases are off balance sheet, and capital leases are treated as capital assets on the books. 

Under the new standards, the classification of leases has changed, along with their placement on the balance sheet. Other changes include:

  • The definition of a lease
  • How initial direct costs are defined
  • More extensive disclosure requirements
  • The treatment of lease and non-lease components

 Leases Under the Old Standards

GAAP IFRS
Old Standard ASC 840 IAS 17
Classification of Lease Determined based on criteria of 4-part test (ASC-840-10-25-1) No specific criteria, but the substance of the transaction
PV of Min. Lease Payment Lesser of the incremental borrowing rate or known implicit rate (ASC-840-10-25-31) Incremental borrowing rate or known implicit rate
Location Capital – balance sheet

Operating – off balance sheet

Capital – balance sheet

Operating – off balance sheet

New Standard ASC 842 IFRS 16

 

Major Differences

GAAP IFRS
Approach Accelerated expense method or straight-line method Accelerated expense method
Classification of Lease Determined based on the criteria of a 5-part test and no more bright lines No specific criteria:if substantial risk transferred, then considered a finance lease; all others considered an operating lease
Location Both finance & operating leases will be listed on the balance sheet (except short-term operating leases) All leases will be listed on the balance sheet
Approach New quantitative and qualitative disclosures No qualitative disclosures – required to disclose substantial information in the notes

Read a detailed breakdown of the new lease accounting standards here and here.

 

Who is affected by the new standards

All companies that lease assets are affected by the new standards. They dictate that all leases with terms longer than 12 months without a bargain purchase option must be recorded on balance sheet. That applies to vehicles, equipment, and real estate.

 

 Industries most affected

ASC 842 and IFRS 16 are set to have wide-ranging effects across most industries:

 

Industry Potential Compliance Challenges
Healthcare
  • Lease volume is high and requires legwork to gather a complete inventory.
  • Accounting for equipment leases in which cost is based on usage requires thorough knowledge of the new standards.
Manufacturing
  • Procurement processes often vary across the enterprise, making inventorying leases more difficult.
  • Leases include maintenance, which makes accounting more complex.
Logistics & Transportation
  • It’s common for leases to be embedded in service contracts – and lease volume may double under the new standards.
  • Decentralized operational structure makes identifying leases difficult.
Energy,
Oil & Gas
  • Identifying whether access to private property is considered a land easement or a lease requires intensive contract scrutiny.
  • If contracts have asset retirement obligations, lease accounting software must be able to account for it properly.
Retail & Restaurants
  • Companies in this sector typically have a high volume of leases distributed across a large geographic area.
  • Build-to-suit arrangements come with major implications for accounting under the new standards.
Banking & Financial
  • ATM leases raise questions about whether the space the ATM occupies is considered a lease or an easement.
  • Leased buildings with advertising or satellites on the roof raise questions about whether those areas are part of the lease.
  • Colocation data storage arrangements could also have embedded leases.

 

Why embedded leases are a particular challenge

One of the biggest challenges companies are facing is identifying their embedded leases. Obvious leases, like real estate and equipment, require legwork to gather, but companies are at least aware of their existence.

 Embedded leases, which are leases that are embedded within service, outsourcing, and maintenance contracts, require a much more complex process. Some examples of embedded leases include:

  • Warehousing contracts – these are viewed as outsourcing contracts, but the agreement may contain language that meets the standards of a lease.
  • Security contracts – these are service contracts, but if they also contain access to scanners or equipment, those can be considered embedded leases.
  • Transportation contracts – these contracts may contain embedded leases for the trucks that are being used.
  • Data storage contracts – much like warehousing contracts, these agreements could include embedded leases for both the servers or the space the servers are stored.

Many times, the departments that are procuring these contracts have no idea that leases are embedded in them. This is one of the aspects of the transition process that companies find most daunting; getting departments outside of accounting to provide their contracts so they can be reviewed for embedded leases is a resource- and time-consuming process.

 

Why Excel is not the right solution

Accountants live by Excel. It’s a robust software that can be programmed to do almost anything – or so many think. But to comply with the new standards, Excel simply won’t cut it. There are too many opportunities to make mistakes.

Plus, Excel can’t be programmed to handle the complexity of ASC 842 and IFRS 16. Take the practical expedients, for example. There’s no way to build the election of practical expedients into an Excel spreadsheet. That’s why many software solutions have cropped up since the standards were released.

 

To comply, companies need a purpose-built solution

To address the complexity of the new standards, companies must look to software solutions specifically designed for IFRS 16 and ASC 842. The software should be able to address the accounting, reporting, and document management needs your company, auditors, and regulators require.

Companies also need to work with lease accounting experts who can help them navigate the complexities and nuances of the new standards. One of the biggest changes in GAAP is that it’s no longer rules-based; the new standards are based on principles. Accountants need to make a lot of judgement calls, and to do that, they need to have confidence in their understanding of the new standards.

 

Choosing the right solution

Implementing a lease accounting solution is a major decision and can be a time-consuming process. When comparing solutions, companies should consider:

  • Whether the software supports its internal controls (basically, does it require an approval process) – this is particularly important for SOX compliance
  • Whether the provider has been issued a SOC report
  • User reviews – and whether reviewers are accountable for day-to-day lease accounting
  • Feedback from fellow accountants

One major pitfall to avoid is focusing on price alone. While budget constraints may make that a tempting option, it will only lead to costly headaches in the long run.

The same goes for choosing a lease management software that wasn’t built for accounting. When the new standards were announced, many lease management companies added accounting modules to their software. However, those programs come up short because they weren’t built with the expert advisement of lease accountants. Companies that choose these solutions risk non-compliance and the fallout that comes with it.

Read this blog for a deeper dive into what companies should focus on as they compare lease accounting solutions.

How the new standards will affect a company’s processes

As companies transition to the new standards, they’ll need to implement processes that, ideally, will remain in place long after the compliance deadline.

Contracts need to be routed through accounting

All new contracts should be routed through the accounting department for review. Not only should the accounting department extract the data they need to account for obvious leases, like vehicles and real estate, they also need to examine contracts to determine if they contain embedded leases. Other departments won’t have the knowledge required to make that determination.

 

All lease documents will be housed in a centralized repository

Another outcome of transitioning to ASC 842 and IFRS 16 is that all documents related to leases will be housed in one place. Currently, many companies take a siloed approach to lease management. Lease documents are often housed in disparate ways, dictated by regional leadership, system limitations, types of leases, etc.

With all documents housed in a single software, anyone who needs access to lease documents can find what they need. This also provides an opportunity for teams that lease to receive alerts on lease renewals and other critical dates, making it easier to prepare for renewals and terminations.

The hidden benefits of the new standards

The silver lining of implementing the new standards is that departments should work together more seamlessly to manage and account for leases. In siloed environments, accounting teams are typically making up for disparities in record-keeping by creating multiple spreadsheets to route throughout departments. Transitioning to the new standards provides an opportunity to integrate processes and tools so all stakeholders march to the beat of the same drummer.

Many companies that have already implemented lease accounting solutions have found that their facilities, procurement, and other leasing departments provide more complete data when entering into new contracts. The result is fewer accounting hours are spent gathering information and more time is devoted to achieving core business goals.

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