If you thought you could rest after adopting the ASC 606 standards and updating the way that you account for contracts with customers, it’s time to start bracing for the next change your business will experience. ASC 842/IFRS 16, commonly referred to as the lease accounting standard, is another joint effort move by the FASB and IASB to create a unified and global accounting standard.
Expected to have a significant impact on the way companies account for leases, a recent KPMG study found that few companies were ready for the changes taking place in the coming months.
The Basics: ASC 642/IFRS 16
Released in the first quarter of 2016, ASC 642/IFRS 16 is designed to provide a significant improvement to financial reporting. However, according to the FASB, it also will be a change for many organizations—particularly those who engage in significant activities as a lessee:
“The standard will increase transparency and comparability among organizations that lease buildings, equipment, and other assets by recognizing the assets and liabilities that arise from lease transactions.”
Much like the last major change to the accounting standards (ASC 606), this will provide a long-term simplification to the way companies operate and report—but will pose a variety of challenges as many organizations will need to make adjustments in the near future.
Impact on the Balance Sheet
Depending on the type of lease, the change could have a significant impact on the balance sheet, as lessees will recognize operating lease liabilities based upon the present value of remaining lease payments and corresponding lease assets for operating leases with limited exception.
In simple terms, the FASB defines the transition as moving operating lease obligations from the footnotes to the balance sheet. While this sounds simple, imagine adding hundreds of thousands, millions, or in the case of some public companies, billions in liabilities to your balance sheet:
- Verizon’s minimum future rental payments under non-cancelable operating leases blew up by $18.2 billion in their most recent 10-K
- Delta Air Lines reported $12.8 billion in future payments.
- Starbucks added $5.7 billion.
Additionally, lessees and lessors will need to provide additional qualitative and quantitative disclosures to help financial statement users assess the amount, timing, and uncertainty of cash flows arising from leases.
The new standard is currently being rolled out—ASC 642 is currently in effect for public companies and will soon take hold for private companies:
- For public companies, the new standard will be effective for fiscal years and interim periods within those fiscal years beginning after December 15, 2018.
- For private companies, the new standard will be effective for fiscal years beginning after December 15, 2019, and interim periods within fiscal years beginning after December 15, 2020.
Many Companies Unprepared for New Standard
As with ASC 606 in years past, few companies are prepared for these changes, as discussed on the NetSuite blog and podcast. In a recent blog, the software provider noted the following:
- Only 3% of respondents said their lease project was complete.
- Among those still working on their projects, 67% said that they were not on schedule due to the challenges they were facing.
- Only 44% had identified their leases and just 25% had assessed the accounting impact of ASC 842 and/or IFRS 16 on their business.
- 45% of companies believe they have software that can manage the process, but only 16% have developed the requirements necessary for implementation.
Knowing this, many companies may find themselves in a similar situation as they did with ASC 606, seeing implementation timeframes go long and dates sneaking up on them.
Preparing for and Addressing Challenges from the New Lease Standard
NetSuite contributor Christopher L. Miller, CPA, MBA, CMA, CITP notes that there are key steps to prepare for the new standard and four challenges you may face when doing so:
Conduct an Accounting Impact Assessment
First, make sure you have conducted an accounting impact assessment on how the standard will affect you.
Resource the Team
Second, understand who is impacted and provide them with the necessary resources. Complying with lease accounting is a cross functional effort, even though it is concentrated in the accounting team for the final compliance results. For example, those who can help your business prepare include the real estate team, office managers, etc. to help you find leases that require abstracting.
Prepare for Challenges in Identifying, Establishing Borrowing Rates, and Abstracting Leases
Likely one of the hardest parts will be making the change from the current standard to the new one. With the help of your transition team, you will need to identify embedded leases, establish an appropriate incremental borrowing rate (IBR), abstract and construct a lease, and enter it into the system.
Identify Embedded Leases in Service Contracts or Intercompany Transactions
One of the challenges in adoption is the identification of embedded leases. Any service contract that exists may have an embedded lease. If equipment or space is being allocated, there could be a lease. Additionally, you need to track the same scenario in your intercompany agreements, as certain allocations may be embedded leases you will need to evaluate.
Establishing an Appropriate Incremental Borrowing Rate (IBR)
If it is available, a lessee-company should discount lease payments using the interest rate implicit in the lease itself. However, if this is not apparent and the lessee does not have the information available, accountants must instead determine its incremental borrowing rate.
FASB’s ASC 842 guidance defines the incremental borrowing rate as:
“The rate of interest that a lessee would have to pay to borrow on a collateralized basis over a similar term an amount equal to the lease payments in a similar economic environment.”
This does present challenges, as IBR is not the same for all assets, even in the same class. Additionally, if you do not have outstanding debt, you may need to consult outside experts to determine the incremental borrowing rate. Companies likely will need to look to an index of the costs of borrowing for comparable companies in their same industry with similar credit ratings to their own. Then, make adjustments that should be based on:
- the underlying asset that is being leased
- the terms of the lease, and
- differences between the lessee and the comparable companies used in the index
Abstracting and Entering Leases into a System
In order to construct a new lease ready for the new standard, you need to complete an abstracting process using the following four elements:
- the commencement date,
- the end date,
- the payment
- the interest rate
If you are not ready for the standard, you should begin looking for a system that can handle the lease needs, providing a strong fixed asset module or lease-focused add-on ready for the changes.
Integrating a Lease Accounting System into the Existing Environment
In their recent Spring 2019.1 update, NetSuite added a variety of compliance functionality including the ability to calculate and report under the new standards. Additionally, the company offers even more granular applications ready to handle the changes.
For example, NetSuite customers that need a complete lease accounting solution could use certified platform applications, such as NetLease fully compliant on the Lessor/Lessee side, or prebuilt third party connectors if necessary.
Prepare for the New Lease Accounting Standards Today
With the standard beginning to affect calendar-year private companies in just over five months, you are running out of time to make changes to the way you account for leases. In a recent episode of the NetSuite Podcast, experts dove into the most important facts to know about the standard and how to best prepare. In this, NetSuite in-house expert Carrie Augustine, CPA and Oracle NetSuite’s Software Industry Expert discussed even more changes and challenges.
Augustine explains what changes to expect from ASC 842, especially with leases that might have been recorded as operational under the previous standard and are now considered capital leases. She dives into the impact these changes will have on a Company’s Balance Sheet, including the monthly adjustments that will need to be considered for net present value and interest.
Get to Know MIBAR
At MIBAR, we have seen standards evolve and solutions evolve alongside them, and understand that companies often face challenges adopting new standards. However, with the right planning and software, you can make your transition easier. As a leading provider of NetSuite for growing companies, we help organizations like yours save time and money with ERP, CRM, and business intelligence products designed to deliver. Get to know more about NetSuite, the work we do, and contact us for a free consultation.