Assessing the Implementation Challenges of IFRS 16 & FASB ASC 842
The impending changes to international accounting standards are set to shake up the reporting practices of all businesses who use forms of leasing in order to operate.
The savviest of the companies most likely to be affected have already put means in place to cope with the changes of IFRS 16, despite the current two-year buffer until the 1st January 2019 implementation deadline. That is because the challenge put to organisations, thanks to the changes in lease accounting, will affect how businesses treat leasing and how the company will be viewed as a whole when, effectively overnight, the entire lease portfolio will appear on balance sheet.
“Effectively overnight, the entire lease portfolio will appear on balance sheet.”
Reminder: What Changes Under IFRS 16 and FASB ASC 842
After years of consultation and development, IFRS 16 will see important lease accounting changes. In short: all leases, including operational leases, will have to be represented on balance sheets in order to give a fairer representation of the true state of a company when in operation.
The new standards bring greater clarity and comparability of companies’ financial statements as under the new guidelines, companies will need to account for almost all leases ‘on balance sheet’, recognising both a right of use asset and a lease liability arising from the agreement.
Central to the creation of the new standard was the fundamental aim of improving the transparency of financial statements through the recognition of lease commitments on an entity’s balance sheet
The deadline for complying with this new standard is 1st January 2019 for those affected by IFRS 16 (non-USA based) and 18th December 2018 for those affected by ASC 842 (USA based). However, some businesses will be required to include retrospective reporting in financial years prior to these dates.
There are some exceptions, however, which permit certain types of leased items to remain off balance sheet. These items will be classed as low value (i.e. that they would cost less than $5,000 to purchase when new – IFRS 16 Only) or short term (with a lease duration of less than 12 months).
These concessions are in response to the feedback that the body who drafted IFRS 16 received from the wider community and aim to reduce the cost and complexity of complying with the new standards.
What are the Biggest Lease Accounting Implementation Challenges?
Several challenges exist surrounding implementing and complying with the new standards. From collating the lease information required for compliance to identifying gaps in IT systems and infrastructure through to the implementation of the necessary lease accounting software. The lease accounting implementation challenges facing lessees are complex and plentiful. The fact that many businesses are yet to start their implementation project or gain an adequate grasp of all their global lease data only makes the challenges more daunting.
Creating a Centralised Database of Lease Information
IFRS 16 and FASB ASC 842 require companies to produce comparative financial statements for up to 2 years prior to the implementation. To achieve this, companies will need to have a complete and historic record of all of their lease data. However, to do this requires the complex and time-consuming process of collating and reviewing all active lease data across the company to produce the comparative reports. This process is made all the more complex for large organisations, whose lease information is often disjointed and dispersed both geographically and departmentally. To make the transition process as smooth as possible, companies should look towards the deployment of sophisticated but simple to implement lease accounting software, which will enable them to create a centralised database of their entire lease accounting information.
Lease Data Gaps
Lessees need access to a minimum amount of data for every one of their lease contracts to run the necessary impact assessments. A considerable number of lessees may be missing key data regarding their leases, assets and liabilities. Sourcing, validating and applying these figures, dates and descriptors will be a lengthy process that will involve considered research, negotiation and calculation, all delaying implementation.
The Clock is Ticking
Lessees may feel that (at the time of writing) over 20 months is ample time to consolidate all of the relevant leasing information and get it ready for compliant reporting. However, the need for disclosure considerations for the year prior to implementation and the lengthy data gathering and analysis phase will mean businesses will be pressed for time. Similarly, companies are advised to run impact assessments and What-If scenarios to determine the best approach for the adoption of the new standards. Assurance and preparation measures take time and can be easily underestimated. So, the sooner they begin, the better.
The impact of the change also needs to be communicated to stakeholders and allowed for in terms of forecasting and long-term planning.
The Impact on Balance Sheets
The new standards aim to provide greater transparency of lease commitments in financial statements. They will stop the “off-balance sheet” accounting treatment of operating leases. These changes are set to significantly impact a company’s income statements as well as its reported profit performance, financial ratios, and other key performance indicators (KPIs) that are important to effective stakeholder communication.
Under IFRS 16, The International Accounting Standards Board (IASB) approximate that bringing all leases on balance sheet will increase earning before interest, taxes, depreciation and amortisation (EBITDA) by 10%. Other KPI’s will also be impacted. Total assets are set to rise, due to the increased recognition of the right of use assets but their carrying amount will fall more quickly than the associated liabilities, which will give, rise to a fall in equity (just as purchase of an asset would cause such a fall). Similarly, financial debt is set to increase, as will earnings before interest & tax (EBIT), operating profit, gearing ratio and operating cash flow. Whilst Profit before tax should be materially unaffected, on the other hand, the equity ratio is set to decrease due to higher financial debt. Total asset turnover is also set to decrease.
However, the impact on financial metrics under the new FASB standard – ASC 842 is expected to be lower than that of the impact of IFRS 16. This is largely because FASB’s new standard has retained the existing lease classification of a finance (capital) lease and an operating lease for P&L recognition, as well as their associated cashflow and P&L recognition. This means that cash flows and P&L remain largely unchanged.
However, there are numerous KPI’s and financial metrics that will be impacted under the new FASB standard. Asset turnover as we have seen will decrease, as will return on assets, return on capital employed, quick ratios and net worth. The new standard will also require the recalculation on certain KPIs such as EBITDA and debt to equity.
What’s more, the changes to lease accounting are expected to impact organisations’ existing loan credit ratings, borrowing costs and debt/loan covenants.
Taking this into consideration, it’s imperative that businesses are fully aware of how the new standards will impact critical financial metrics and performance KPIs. These impacts should also be clearly communicated to both internal and external investors and stockholders.
A Systems Update is Likely Required
All of this equates to a new approach and attitude towards lease management, lease accounting and lease reporting. If a manually controlled spreadsheet is the software used to manage all leasing data, it requires close and constant management in order to make sure the portfolio is operating as cost efficiently as possible, and is well maintained and is being reported fully and correctly. It may be better to evaluate and implement a largely automated software system which takes the time and hassle out of reporting on your lease portfolio.
Innervision’s lease accounting solution, LOIS – Lease Accounting (“LOIS”), is an advanced application that supports both lease accounting standards, IFRS 16 & FASB ASC 842. The solution allows users to account for and manage all lease asset types, ranging from IT, plant & machinery to material handling equipment, vehicles and property. LOIS provides users with all the tools necessary to produce the accounting information required to accurately complete the financial statements obligatory for compliance; including income statement, cash flow and balance sheet.
LOIS, will even run the critical amortisation schedules, journal entries and disclosure summaries.
Getting Prepared: A 7 Steps Guide To Lease Accounting Compliance
If you are interested in getting more of a grasp of how the changes to lease accounting will impact your company and what steps you can take to help ensure full compliance with the new standards, you should check out our “How to Comply With Changes to Lease Accounting” e-book.