Businesses run on cash and borrowed money. The better the cash flow, the greater the flexibility to take advantage of a business opportunity or a shift in market conditions. By embracing this universal truth, CFOs have realized the value of leasing to keep cash on hand for investments that would likely yield profits that are higher than their interest cost. The concept may sound simple, but the administration and accounting of these contract and financial obligations just became more involved.
Last year, the Financial Accounting Standards Board (FASB) issued new guidance for lease accounting, with new reporting requirements starting on December 15, 2018, for ASC 842 and January 1, 2019, for IFRS 16. As the mandatory effective dates loom, approximately 60% of CFOs are keenly aware of the changes, according to David Furgason, managing director at Deloitte Consulting LLP, during the Webcast “Leases on the Balance Sheet: Compliance with the New Standard,” hosted by Institute of Management Accountants (IMA). However, Furgason also noted some inconsistency among finance leaders: “Over 80% have yet to assess whether their financial technology and underlying architecture are up to the task of complying with the standards. And this same percentage of CFOs do not have the budget available to address any gaps.”
Furgason was joined by Imran Mia, head of the Center of Excellence for Finance at Nakisa, and Pete Graham, director of Finance Solutions at SAP, to examine the implications and timing of IFRS 16 and ASC 842 and strategies for adopting them.
Lease accounting standards call for simplification and optimization
Considering that less than two years are left until businesses must establish compliance, CFOs have a heavy load to lift in a short time. “IFRS 16 and ASC 842 will undoubtedly involve new processes, staff training, technology upgrades, more detailed reporting capabilities, and technical accounting assessment,” warned Mia.
In short, lessees will be required to recognize operational and capital leases on their balance sheet, a significant change from current accounting practices that account only for capital leases. The standards align underlying principles of the new lessor model with those in FASB’s latest changes in recognizing revenue and eliminate the bright-line tests mandated by U.S. GAAP for determining lease classification.
The key to preparing for this transition is clear visibility into assets and contracts. Graham advised, “The first step is to get a better understanding of the lease portfolio and which major category each investment falls under – beyond operations and capital finance.”
All long-term leases must be individually accounted for and evaluated to determine their impact on the balance sheet, paying particular attention to details such as the asset’s fair value, estimated useful life, and incremental borrowing rate. Agreements may contain multiple renewal options, escalation terms, and termination clauses that may be hidden in the fine print. Also, underlying lease and non-lease components may be embedded in service contracts and tangible real estate and property.
Gathering lease information will get 80% of this work done, which can be complex and cost-intensive because data formats may vary. The remaining 20% command an assessment of the current financial landscape and implementation of a seamlessly integrated lease-accounting solution that stores data and enables accurate calculations of risk and exposure.
“Ultimately, the finance department is responsible for communicating business policies for compliance and the identification of all leases,” suggested Furgason. “All relevant business process owners should be brought together to define a global model for the end-to-end lease accounting solution. Then IT can locate all lease source systems, financial systems of record, and integration points for the chosen technology. While the lease-accounting technology implementation may be six months in duration, from planning through implementation, such an exercise can take upwards of 12 months to complete.”
While capturing and consolidating lease agreements into a central system creates the foundation, full compliance with IFRS 16 and ASC 842 demands attention to specific aspects of finance operations and business processes, including:
- Integrated business processes: Consideration must be given to the end-to-end process including the general ledger, asset accounting, procurement, accounts payable, vendor management, and, in some cases, equipment maintenance.
- Application of judgment and estimation: Since nearly every lease will be recognized on the balance sheet, it is important to distinguish between leases and services and your customers’ right to direct the use of a particular asset.
- Income and property taxes: Potential federal and state income tax can be situationally applied to finance and operating leases, requiring the involvement of the business’ tax department.
- Covenants: Careful examination of the lease liabilities outside of traditional debt may be necessary – depending on how various debt agreements are defined, limited, and governed by GAAP covenants.
- Internal controls and business process environment: Because leasing will become more relevant to financial statements, auditors and regulators may apply additional scrutiny in the design and effectiveness of associated controls under Sarbanes-Oxley. Businesses should examine internal controls for capturing, calculating, and accounting for leases and issue organizational communication, conduct employee training, and establish change management as needed.
- Disclosure reporting requirements: Existing reporting functions must include quantitative attributes such as lease costs, cash flows, maturity, lease terms and commitments, and discount rates, as well as qualitative considerations including general descriptions, terms, and conditions of the lease.
The time to enforce overdue changes in lease management is now
Pervasive loss of efficiency, capital funding, and transparency in lease management are emerging as a warning shot for the immediate need for change. Mia observed, “Businesses are paying a significant amount in evergreen fees for past-term leases and lost assets. Leases are traditionally managed across a single business unit with spreadsheets, disparate applications, or a file residing on someone’s laptop. Meanwhile, the combination of disconnected processes and field-triggered leases are adding stress to the ability to conform to accounting standards.” This environment results in not only unnecessary monetary loss, but also suboptimal leases, poor buy decisions, and accumulated small-ticket-item costs.
Although the accounting itself may not be a difficult task thanks to the technology that’s available, IFRS 16 and ASC 842 place a bright spotlight on how lease data is managed. “With known and unknown agreements spread across regions, business and operating units, and subsidiaries, it can take a herculean effort to capture and aggregate every item and become adept at deriving insight on exposure. It doesn’t matter if the business is a large conglomerate or a small startup; everyone is impacted the same way,” said Graham. “Additionally, experience has shown that it is critical for customers to ensure that they are using the latest technology solutions, running any available diagnostics and related analysis, and implementing all suggested product updates in a timely manner.”
Watch the on-demand replay of the Webinar “Leases on the Balance Sheet: Compliance with the New Standard,” co-presented by Nakisa, Deloitte, and SAP to learn how to gain visibility into your lease exposure. (Registration required.)