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New ASC 842 and IFRS 16 lease accounting for real estate and assets
Leasing is a common financial solution that 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 new regulatory lease accounting standards ASC 842 and IFRS 16 set forth by the US-based Financial Accounting Standards Board (FASB) and allied International Accounting Standards Board (IASB) drastically change the way leases are treated in accounting and have large impacts on a company’s balance sheet and financial position.
What is the difference between an operating and capital lease?
There are two kinds of lease accounting classifications: operating and finance lease. An operating lease is treated as an operational expenditure only, based on straight lined payments. A capital lease (also called financing lease under IASB) is a capitalized 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 today can represent between 1 and 66% of the balance sheet. This wide range indicates differences in ownership status; some organizations chose 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 organizations. Future liabilities emerging from these operating leases are not represented on the balance sheet.
New 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 new lease accounting standards relevant for compliant property and asset lease accounting management are ASC 842 and IFRS 16. They were published by FASB and IASB in February 2016, and will be effective for public companies starting in the fiscal year 2019.
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Articles & white papers | 03/23/2017
FAQ - How new lease accounting standards will impact your business
A lot will change in lease accounting starting in 2019. From January 1, 2019, the Financial Accounting Standards Board (FASB) and the International Accounting Standard Board (IASB) will have new standards, ASC 842 and IFRS 16 respectively. This immediately raises a number of issues. In this FAQ you will find our answers to five frequently asked questions about lease accounting.Learn more
What are the important changes in lease accounting?
1. Operating lease on balance sheet
The new ASC 842 and IFRS 16 standards incorporate changes in the way properties, tangible and intangible assets are recognized for leases. In the previous situation, as described in ASC 840 (FASB) and IAS 17 (IFRS), operating lease obligations are not on the balance sheet whereas capital leases are on the balance sheet. Operating leases were only disclosed in the footnotes at the organization’s financial statements. The new lease accounting standards ASC 842 and IFRS 16 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 automatically recognized as finance leases on the balance sheet under IFRS 16 and mentioned as operating lease on the balance sheet under ASC 842. PwC research showed that the increase in interest bearing debt will increase to 58% on average but could increase by more than 200% for industries with many leased properties and assets. Related financial indicators like company's Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA), leverage and solvency will change accordingly. The lease accounting standards leave some space for interpretation but require an assessment as part of the lease management process and clear documented reasoning and decision frameworks to ensure compliant reporting. Download our white paper for a more detailed summary of the changes FASB will cause to your lease accounting.
2. Capitalization of more cost factors
In the previous IASB and FASB lease accounting systems, only basic rent was included in capitalization, however, the new 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 acquisitions costs and costs for investments to remove tenant improvements after the lease are included in the right of use and capitalization of these amounts on the balance sheet.
3. Inclusion of lease extensions and indexations
Optional extension periods need to be included in capitalization when “reasonably 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 reasoning for eventual exclusion needs to be accepted. Specific attention is required on the impact of indexations. Any changes in the index require under IFRS 16 a complete recalculation, which can elevate the volatility of lease accounting figures of right of use and liability.
4. New disclosures and SOX compliance
In addition to the recognition of leases on the balance sheet, the new ASC 842 and IFRS 16 accounting standards by FASB and IASB 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 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.
5. IFRS 16 and ASC 842 requires more accuracy in the lease administration process
The new ASC 842 and IFRS 16 lease accounting systems require the capitalization of almost all real estate, property and asset leases. They also require registering 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 is fundamentally changing, lease scenario planning, balance modeling, and assessments become important in the decision making process that will include involvement from the controller and CFO.
Are you ready for the transition?
The ASC 842 and IFRS 16 standards become effective for public companies starting at the beginning of fiscal year 2019, but also include the demand to report on its regulations over the financial years starting in 2017. During the transition period between 2017 and 2019, the reporting requirements as defined by ASC 840 and IAS17 are still effective, so a twofold lease calculation and reporting is required, without a double payment and accounting.
Lease accounting in IWMS
With the upcoming changes in lease accounting, organizations 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 FASB and IASB require a precise administration of all lease contract related costs and payments, with the ability to know who did what when. This calls for a professional lease administration as available in 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 that is implemented on top of the lease administration in IWMS. In both cases with seamless integration to your financial system.