The Financial Accounting Standards Board is expected to release its long-awaited lease accounting standard this quarter, and companies are bracing for the impact on their balance sheets.
The changes will require companies to gather significantly more information and require more management judgments each reporting period, according to PricewaterhouseCoopers. The changing model might affect financial ratios and metrics, “lease vs. buy” decisions, accounting processes and controls, along with technology.
“With that effort there comes a bit of compliance around ensuring that you have the full population of your leases and all the data that you’ll need to do the ultimate accounting, coupled with the fact that this information may not be centrally housed in one location,” said Sheri Wyatt, managing director of PwC’s Capital Markets Accounting Advisory Services.
While many people believe the new standard simply means putting operating leases on the balance sheet, Wyatt sees the effort going deeper.
“The view is that for U.S. GAAP issuers it’s going to be largely a balance sheet exercise, because from the P&L or income statement perspective the accounting treatment will be virtually the same,” she said. “But with the prominence of these leases coming on the balance sheet, then that starts to put a bit more focus on companies’ processes and controls as well as the data.”
For those companies with mostly finance leases, there won’t be as much of an impact because those leases are already on the balance sheet. According to FASB, finance leases will be accounted for in substantially the same way as capital leases are under current GAAP.
The new standard will mainly affect companies where the leases have been kept off the balance sheet until now. It should not have much of an impact on corporate profits, though, or greatly surprise many investors and financial analysts.
“From a P&L perspective, if something still meets the characteristics of an operating lease, then you’re still going to have the same P&L recognition pattern that you have under current GAAP, so we’re not expecting to see as much volatility or change in the income statements,” said Wyatt. “With respect to the additional leverage, all companies will be in the same position, so I don’t know that this is necessarily going to take too many investors by surprise, particularly because companies are required to disclose under current GAAP what their lease commitments are. Analysts already do some analytics around that and apply a multiple to come up to what the potential balance sheet impact would be. Unless there’s a situation where the company may, through their investigation process, find more leases than they originally had disclosed, I don’t know that there will be too much surprise for investors.”
However, analysts are going to learn more about the lease terms. “Some of the information that the analysts didn’t have were the assumptions around the lease term and assumptions around the discount rate, and that can obviously have an impact on what companies are putting on their balance sheet compared to what analysts may have been expecting,” said Wyatt. “It remains to be seen whether there are going to be large variances between them.”
Companies will also need to provide more disclosure about embedded leases now. “This is a change in GAAP where the definition of what contains a lease may be different from what it was before,” said Wyatt. “For example, a company may have a service arrangement that contains an embedded lease under current GAAP, but because that accounting treatment was an operating lease it may or may not have been disclosed in their disclosures. Now under the new standard, where it is changing the definition of a lease embedded in a contract, you could find a situation where there may be more leases, although we are currently speculating there may be less embedded leases under the new standard, as opposed to today. It may be kind of a push and pull, where companies might have previously not disclosed as many leases, but at the same time they may have a reduction in leases because of the new standard on embedded leases.”
Trade groups like the Equipment Leasing and Finance Association have been sounding warnings about the impact of the new standard on equipment-leasing companies.
“The concern that I’ve heard has been the potential risk for lessees switching from leasing to buying, as well as potential additional information needs that companies may request from lessors in order to do their accounting, in particular where a contract may contain both a lease and a non-lease element and wanting to get the right information to be able to do the allocation between those two elements,” said Wyatt.
Lessees may elect to work with their lessors to modify the terms of their leases to lower the impact on their financial statements.
“Companies may start to look a bit more closely at their lease vs. buy decisions as well as their procurement process just to ensure that they are making the right decisions around whether it’s more economical for them to lease vs. buy, since at least from a balance sheet perspective you’ll get to a similar leverage as you would from buying it,” said Wyatt.
There are also differences between the upcoming FASB standard and the version released last month by the International Accounting Standards Board for companies using International Financial Reporting Standards (see IASB Releases Lease Accounting Standard). Those might have some impact on multinational companies.
“The differences are isolated into two areas, one in terms of scoping under U.S. GAAP will have a scope exception, or what we could exclude from measurement will be short-term leases, whereas under IFRS they have a concept of small-ticket leases as well as short-term leases,” Wyatt explained. “There could be some differences there, as companies start thinking about their policies and deploying it across their organization will need to keep in mind. The biggest difference for multinationals is going to be the fact that U.S. GAAP will have a dual model, where you’ll have a finance representation, the P&L, as well as an operating presentation, whereas under IFRS everything is going to be a financing. That does create some challenges, particularly from a systems perspective, in ensuring that whatever system that a company chooses to use, that it can handle multi-GAAP.”
Companies will need to start preparing for implementing the new standard over the next few years and some will need to produce comparative financial statements as they make the transition. “The effective date of the standard is 2019, so it is at least three years out, but for public companies that have comparatives you’re looking at 2017, 2018 and 2019,” said Wyatt. “FASB in some of their discussions has stated that because of some of the simplifications that they’ve done with the models since they first started the project that they don’t expect implementation to be too challenging.”
She believes companies will need to spend time accumulating the data and perhaps consider implementing a new system to handle both the new leasing and revenue recognition standards.
“The implementation process will take some time, but companies are also still in the midst of implementing the revenue recognition standard,” said Wyatt. “There will be a prioritization given that revenue becomes effective at least a year earlier than leasing.”
Wyatt believes a staggered implementation probably makes sense for many companies, but she noted that under both U.S. GAAP and IFRS, FASB and the IASB have allowed companies to adopt the standards early. “At least under U.S. GAAP, it’s as early as when it’s issued,” she said. “Under IFRS it’s no earlier than when you adopt the revenue recognition standard. That gives companies some flexibility and is a bit of a difference from the FASB’s typical protocol. They’ve generally not allowed early adoption of standards, but I think they want to give companies that flexibility to say if it’s more economical for you to adopt those at the same time you have the ability to do so.”
Companies may decide to change their procurement processes when entering into leases under the new standard. “I don’t think companies are necessarily required to look at their procurement process, but it gives them an opportunity to look at their process,” said Wyatt. “They may not have focused on it as much because perhaps the procurement and the decisions were largely around getting to operating lease treatment as opposed to getting the best deal for the organization. If a company is thinking about potentially modifying their procurement process or looking for ways to identify potential synergies that they can get from leasing equipment from a consolidated group of vendors as opposed to a more dispersed group of vendors, they can get some economies of scale from that. You can get some of those cost savings from consolidating vendors, thinking about the end-of-term decisions and whether you are making the right decisions when you get to the end of the lease, as well as lease vs. buy decisions, and getting a more robust process around that. The cost savings could mitigate some of the costs of compliance associated with implementing the standard.”
Companies can reduce the potential compliance costs with the help of technology. “Companies when they think about the compliance costs may start to get a bit overwhelmed thinking about how they don’t currently have a system or repository for their leases today, and so now they’re going to have to allocate resources in order to ensure that the data they have is accurate and complete, or go through the process of abstracting some of the key pieces of information,” said Wyatt. “I think that gives companies an opportunity to explore technology solutions. We’ve been working with our clients around various uses of technology to help with that abstraction and extraction process so that companies can look to perhaps reduce the cost of compliance by leveraging technology.”