Under the new FASB/IFRS rules, it will no longer be possible to keep operating leases off the balance sheet simply by recording them as a periodic rent expense (above the EBITA line). Instead, companies will have to show them on the balance sheet as an obligation and its related right of use asset. It will also be necessary to record interest and amortization expenses (below the EBITA line).
If your organization is affected by the new rules, you must ensure that you are fully prepared for these dramatic changes. Before you take your first steps on the hazardous journey to FASB 842/IFRS 16 compliance, you need to be certain that you fully understand the potential pitfalls you might encounter along the way.
The new guidance will not affect all organizations in the same way. But if your company has a large portfolio of complex leasing arrangements, you’ll probably have to introduce substantial operational and system changes in order to comply with the new standards. This will potentially disrupt many functional areas within your business — including corporate real estate, financial accounting, financial planning and analysis, financial reporting, tax, treasury and technology.
There will be financial risks too.
The new FASB/IASB leasing model will have a significant impact on your organization’s financial metrics and ratios because of the changes that will affect your balance sheet and income statement. This is likely to have a profound effect on your company’s overall capital structure (including leverage, liquidity ratios and return on investment). It could also have a bearing on your firm’s credit rating.
To make sure your organization isn’t put at risk by the new lease accounting standards, we’ve highlighted 10 key mistakes you should try to avoid.
1. Closing your eyes to the shape of things to come
If your company leases real estate, vehicles and equipment, don’t underestimate the impact that the new FASB ASC 842 and IASB IFRS 16 leasing standards will have on your business. Your approach to lease accounting and financial reporting — and even the necessary capabilities of your accounting technology — will never be the same again after December 15, 2018 (FASB) or January 1st, 2019 (IASB).
That’s why it is so important to take steps NOW to prepare key departments such as financial planning and analysis, financial reporting, tax, IT, and human resources for the future shape of lease accounting.
All of these departments need to be made aware that compliance with the new FASB/IASB standards will require a more systematic approach to the way lease data is collected and extracted in future. You’ll also have to integrate data management and reporting systems, improve processes for sharing data across multiple business functions, and make certain determinations for accounting purposes.
It’s also important to recognize that the new standards will make lease accounting functions much more complex. That means your lease administrators will have to rise to the challenge and enhance their level of expertise.
2. Not being aware of the risks of noncompliance
Experts warn that organizations that heavily utilize leasing of real estate, vehicles and equipment could face severe consequences if they’re not ready to adopt and report under the new lease accounting standards by January 1st, 2019 at the latest.
It will be essential to perform a thorough impact assessment as soon as possible to make sure your organization is fully prepared for the significant changes to the makeup of your income statement and balance sheet from either December 15, 2018 (FASB) or January 1st, 2019 (IASB).
If you fail to comply in time, the levels of risk range from having to bear the cost of additional audit fees in order to get past the 2019 audit, through to auditors refusing to issue an opinion on the company’s financial statements … or even delivering an adverse opinion.
If your company is publicly traded, such a negative report card from your auditors could lead to the potential loss of shareholder confidence or an exodus of investors. In the worst-case scenario, your company could end up being delisted by the stock exchange that trades your shares.
3. Not forming a cross-functional compliance team
With the FASB 842 and IFRS 16 deadlines now only a few months away, it is imperative to establish a cross-functional project team to oversee strategic planning and execution for compliance.
At an absolute minimum, your compliance team should comprise key people from financial accounting and reporting, corporate real estate, financial planning and administration, procurement, and IT — along with representatives from other business functions that will be affected by the lease accounting changes.
Compliance team members should be tasked with thoroughly reviewing your existing lease accounting processes, identifying the changes that need to be made to comply with the new standards, and then defining and adopting updated accounting policies.
Your compliance team should also be responsible for raising internal awareness and giving all relevant staff a good understanding of the implications of the new standards.
4. Not creating a compliance project plan
Because the new leasing standards will touch many different parts of your organization, it will be essential to have a comprehensive compliance project plan (with a dedicated project manager, if possible). This plan will guide the affected departments through all of the steps they need to take to implement and comply.
The plan should cover:
- The three phases of compliance: Preparation, Transition and Adoption.
- The gathering of all relevant lease data.
- Defining and implementing new accounting policies.
- Evaluating new lease accounting systems that will help you adopt the new standards.
5. Not taking a full inventory of ALL your leases and gathering source documents
Do you know the location of ALL your current leases? To be fully prepared for the new lease accounting standards, you must create a full inventory of your leases and any lease-like agreements which may have previously been classified as a Service Agreement.
Your compliance project may be put at risk if you don’t review these documents for completeness. This thorough appraisal should encompass all original leases and all amendments, Memorandums of Understanding, and terms and conditions.
6. Not allocating sufficient resources to implement and achieve compliance
Because the FASB 842 and IFRS 16 changes are likely to affect many different parts of your organization, you should not underestimate the amount of budget needed to cover the associated costs of compliance, as well as the additional company-wide workload.
That’s why building a comprehensive compliance project plan is so important. It may identify the need for a significant increase in spending to address any shortcomings in procedures, internal controls and accounting technology.
If only limited resources are applied across each department, there is a danger that your company won’t be ready to meet the required timeline for compliance.
7. Not reviewing and improving your leasing strategy
With the cost of operating leases set to be classified as an obligation on the balance sheet from January 1st, 2019, the traditional method of using discounted cash flow to analyze lease deals will no longer provide an accurate picture of the impact on your company’s financial statements. In future, items such as lease components and renewal options will have a significant impact on the balance sheet, profit and loss, and shareholder equity.
Reviewing your leasing strategy and renegotiating your existing leases — even if they’re not up for renewal yet — could help you to anticipate and mitigate the impact on your balance sheet.
If you decide to re-negotiate your existing lease terms, it will be essential to make sure your lease accounting system is capable of managing that process and can automatically apply the new terms to the lease management process.
8. Not knowing how the FASB and IASB standards differ
Surprisingly, some people still aren’t aware that there are major distinctions between the new FASB 842 and IFRS 16 rules on several key points. For example, there’s a big difference in the way leases will be brought onto the balance sheet under the two new standards.
This will add extra complexity to compliance and will present a major challenge for some companies — especially multinational enterprises with decentralized operations that fall under both sets of guidelines. Achieving full compliance will be a little easier if you have a single, enterprise-wide lease accounting system that is able to support the differences between the new FASB and IASB standards.
9. Underestimating the new accounting and reporting requirements
In a study by Deloitte, 88% of respondents felt that the new FASB 842 and IFRS 16 lease accounting standards will place a significant additional reporting burden on all lessees of real estate, vehicles and equipment. Some observers believe there could be a four-fold increase in the amount of footnote disclosures on financial statements alone.
Simply relying on the data you currently use for footnote disclosure won’t be enough to meet the new reporting requirements.
As a result, it may be necessary to increase the efficiency and accuracy of your data storage, data collection and data abstraction processes in order to identify, compile, process and analyze all of the important lease data the finance department will require in future. And making sure you protect the integrity of your data will be more important than ever to satisfy auditors.
10. Failing to realize your lease accounting technology is not fit for purpose
The new FASB 842 and IFRS 16 standards will impose greater demands on the capabilities of lease accounting technology. Experts warn that many existing lease accounting systems may need to be updated, or even replaced altogether, because they’ve been made obsolete by the new compulsory rules.
In a 2017 survey by PwC and CBRE, some 43% of companies affected by the new lease accounting standards said they intended to implement a new lease management system to make sure they are compliant. They recognized that, to report lease assets and liabilities more accurately on their balance sheet, they may need to change the policies, processes and IT systems that currently support their lease accounting, administration and procurement.
By avoiding the potentially disastrous mistakes we’ve highlighted here, we hope your organization will have a smooth, risk-free transition to the new standards. You can find out more in our white paper, ‘Why Trimble Manhattan is the right choice for FASB/IASB Compliance’. It answers many of the key lease administration and accounting system questions that are frequently asked by organizations that will be affected by the lease accounting revolution. Book a product demo with one of our Manhattan software experts.