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Lease Accounting - ASC 842 and IFRS 16 standards for real estate and assets
Leasing is a common financial solution that is used by most organisations. It enables companies to use real estate properties, assets and equipment without initial investments and large initial cash outflows. Leasing is also a common practice to increase portfolio flexibility and to free up financing for investments in the core business.
The regulatory lease accounting standards ASC 842 and IFRS 16 as set forth by the US based Financial Accounting Standards Board (FASB) and allied International Accounting Standards Board (IASB) drastically changed the way leases are treated in accounting, and the impact of lease accounting changes have a significant impact on a company’s balance sheet and financial position.
What is the difference between operating and finance lease?
There are two kinds of lease accounting classifications: operating and finance lease. An operating lease is treated on operational expenditure only, based on straight lined payments. A finance lease (also called capital lease under FASB) is a capitalised liability and right-of-use on the balance sheet, thus affecting profit and loss (P&L).
According to research from PwC, real estate properties and assets can today represent between 1 and 66% of the balance sheet. This wide range in percentage indicates differences in ownership status; some organisations choose to own their real estate, on-balance, and others have chosen to rent their properties and assets as operating lease, off-balance.
This lease accounting practice has been questioned by accountants for many years. How realistic are the financial statements on the balance sheet when an on-balance owned property or asset could be sold within a few months while an off-balance operating lease contract could represent a liability for multiple years ahead? Operating leases have been adopted for many good reasons related to liquidity and increased ability to invest in core business activities. However, it showed some negatives in terms of the reduced ability to interpret the actual financial condition of organisations. Future liabilities emerging from these operating leases are not represented on the balance sheet.
Lease accounting standards: ASC 842 and IFRS 16
FASB and IASB have been reviewing the lease accounting systems called US Generally Accepted Accounting Principles (US GAAP) and International Financial Reporting Standards (IFRS). The key objective is to enhance financial transparency by having the liabilities that asset and property leases incur be represented on the balance sheet. The latest lease accounting standards relevant for compliant property and asset lease accounting management are IFRS 16 and ASC 842. They were published by IASB and FASB in 2016, and are effective for public companies since the fiscal year 2019.
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Webinars & videos | 28/06/2018
Webinar - The power of connecting IFRS 16 & Property Management
Articles & White Papers | 06/06/2018
White Paper – Getting from here to there: The steps to transition from IAS 17 to IFRS 16
This white paper, created in collaboration with Accenture, provides an overview of the IFRS 16 standard, the impact it will have on your organisation, and what to consider as you begin your transition from IAS 17 to IFRS 16.Learn more
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What are the important changes in lease accounting?
1. Operating lease on balance sheet
Lease acconting changed under IFRS 16 and ASC 842 standards alter the way properties, and tangible and intangible assets are recognised for leases. In the previous situation, as described in IAS 17 (IFRS) and ASC 840 (FASB), operating lease obligations are not on the balance sheet whereas financing leases are on the balance sheet. Operating leases were only disclosed in the footnotes of the organisation’s financial statements. The latest lease accounting standards IFRS 16 and ASC 842 ensure that lease liabilities are reflected in a more uniform way. All asset and property leases with lease terms of more than 12 months are under IFRS 16 recognised as a right of use and liability on the balance sheet. Under ASC 842 leases need to be classified and recognised on the balance sheet as operating leases or finance leases. PwC research showed that the increase in interest-bearing debt will mount to 58% on average but could increase by more than 200% for industries with many leased properties and assets. Related financial indicators like a company's Earnings Before Interest, Taxes, Depreciation, and Amortisation (EBITDA), leverage and solvency will change accordingly. The latest lease accounting standards leave some space for interpretation but require an assessment as part of the lease management process and clear documented arguments and decision frameworks to ensure compliant reporting.
2. Capitalisation of more cost factors
Whereas in the previous IASB and FASB lease accounting systems only basic rent was included in capitalisation, the IFRS16 and ASC 842 standards also include additional amounts. Cost factors like variable rent, bargains or compelling renewal rents, contingent rentals, residual value obligations, amounts for purchase options, lease acquisition costs and costs for investments to remove tenant improvements at the end of the lease are included in the right of use and capitalisation of these amounts on the balance sheet.
3. Inclusion of lease extensions and indexations
Optional extension periods need to be included in capitalisation when ‘reasonable certain’. This leaves space for interpretation and a significant compliance risk at the same time. During the assessments of the financial reporting by accountants, the argumentation for eventual exclusion needs to be accepted. Specific attention is required on the impact of indexations. Under the IFRS 16 lease standard, any changes in the index require a complete recalculation, which can increase the volatility of lease accounting figures of right of use and liability.
4. Disclosures and SOX compliance
In addition to the recognition of leases on the balance sheet, the latest ASC 842 and IFRS 16 accounting standards also require additional disclosures. These are designed to help investors and other stakeholders to understand property and asset related lease liabilities, the timing of financial commitments and aspects of uncertainty around cash flows arising from leases. In most cases, this additional information has to be Sarbanes Oxley (SOX) compliant, which in turn implies the need to track and record all changes on lease contracts and to prove that decisions have been made in an authorised way.
5. IFRS 16 and ASC 842 requires more accuracy in the lease administration process
The IFRS 16 and ASC 842 lease accounting systems demand the capitalisation of almost all real estate, property and asset leases and require the registration of additional lease related information. This will impact the day-to-day business of lease administration and associated IT solutions. The requirement to disclose information on the timing and uncertainty of cash flows requires a more detailed registration of lease data. Since the financial impact of lease renewals had changed fundamentally, lease scenario planning, balance modelling, and assessments are important in the decision making process that will include involvement from the controller and CFO.
Are you already compliant with ASC 842?
The ASC 842 and IFRS 16 lease standards became effective for public companies starting since the fiscal year 2019 but also included the need to report on regulations over the financial years starting at 2017. During the transition period between 2017 and 2019, the reporting requirements as defined by IAS17 and ASC 840 are still effective, so a twofold lease calculation and reporting is required, without a double payment and accounting. Organisations must make sure they are ready for the changes and have a reliable lease accounting software solution.
Lease accounting in IWMS
With the upcoming changes in lease accounting, organisations need an instrument that enables them to make integrated considerations on their portfolio and asset strategy, lease renewals and lease proposals presented in the language of senior business management, controllers, accountants and other financial professionals. The impact of a lease renewal on the costs and liabilities can be significant and needs to be calculated and reported in a compliant way. The new requirements for lease accounting as set forth by ASC 842 and IFRS 16 require a precise administration of all lease contract related costs and payments in a ‘time-lined’ way. This calls for professional lease administration as available in a mature Integrated Workplace Management Systems (IWMS). Lease accounting is an important additional solution that can be used as a specific accounting system for controllers, or implemented on top of the lease administration in IWMS. In both cases with seamless integration to your financial system.