Public companies faced 5 major challenges while implementing the new lease standards, according to a new report from PwC.
These roadblocks shed light on what private companies can expect to deal with in 2020:
- Automating new lease reporting processes
- Ongoing data capture for new leases or changes to existing leases
- Identifying and accounting for embedded leases
- Strengthening controls for new leasing processes
- Disclosure reporting
The new accounting standards are a formidable undertaking for private companies.
To add to the pressure, the stakes are high to get compliance 100% accurate. Negative side effects are plaguing public companies, including even minor mistakes in reporting. Private companies can expect to be hit just as hard.
One thing is for sure… get compliance wrong, and you’re in for a steady diet of uncertainty and sleepless nights.
Because the new accounting standards have the potential to destroy your company’s financials, we put together a list of possible impacts. It will help you understand the magnitude of lease liabilities and give you a reality check about FASB ASC 842.
#1 - Bank Covenant Misdemeanors
You could end up violating your bank covenants if you fail to fully comply with the new lease accounting standards.
If you have debt arrangements or credit agreements associated with borrowing or credit facilities, there’s probably a loan covenant contained in it. If this debt covenant is breached in any way, it will trigger a default you’ll have to pay.
- Basic fixed-charge coverage
- Current ratio
- Debt service coverage
- Debt to net worth
- Funded debt to EBITDA (earnings before interest, taxes, depreciation, and amortization)
FASB ASC 842 requires companies to bring certain operating leases onto the balance sheet and report them as assets and liabilities.
Let’s say your lender views the liabilities capitalized onto the balance sheet from these operating leases as debt per ASC 842. In some cases, this increase in liabilities on the balance sheet could mean you’re violating your debt covenant.
It’s a fine line to walk.
#2 - Filing a Financial Restatement
A financial restatement is a need to refile financial reporting because of an error or mistake in the original statement.
And financial restatements pack a punch when it comes to the new lease accounting standards.
When auditors are on high alert for mistakes, even the smallest error in reporting (think a typo) will send you back to the drawing board. And while it means more headaches for your team, it also raises eyebrows with investors.
If you’re considering selling now or in the next few years, you need to stay in the good graces of investors. And filing a financial restatement does the opposite.
#3 - A Credit Rating Drop
Any CFO or controller worth their salt knows what a credit rating is.
It’s important for businesses to maintain the highest possible credit rating since the score has a major impact on interest rates lenders will charge you.
In recent years, a short-term credit rating — the likelihood of the borrower defaulting within the year — has become the norm. Combine this with the fact that credit ratings change all the time and one little debt will make even the best score plummet, and you’re perched on a precarious cliff.
#4 - Valuation Decline
The biggest frustration with FASB ASC 842 is the unintended consequences it has on valuation.
Operating leases really aren’t that different from traditional asset ownership and debt from an economic perspective. But with the new lease accounting standard, you’re required to exclude assets and liabilities associated with operating leases from the balance sheet.
This has a significant impact.
It biases financial ratios, which presents your numbers in a whole new — and potentially worse — light. Investors could start questioning your stability.
And when investor confidence falls, valuation naturally declines in its wake.
#5 - Due Diligence Surprises
If your private company is already in the due diligence phase of an IPO or sale, a mistake in compliance reporting could lead to the deal going sideways.
Just consider a few of the items you’ll have to submit for due diligence:
- Financial statements
- A complete list of liabilities
- Debt disclosures
- Industry type and market area
These will all look completely different after you’ve accounted for the changes FASB ASC 842 reporting brings. And it will look even worse if you’ve been penalized for lack of compliance.
Either party has a right to exit the deal during the due diligence time period, and many have taken the opportunity to back out because of problems caused by the new lease accounting standards.
#6 - Saying Goodbye to Your Job
FASB ASC 842 mistakes will really hit home when someone doesn’t have a job anymore.
It’s already happened to companies who didn’t take compliance seriously: The executives responsible for the finances are being kicked out.
Boards of large public companies can’t consciously keep executives on board who’ve tanked the company. Whether it’s their fault or not, these CFOs were the overseers of accounting and missed the mark directing their teams.
This should be a wake-up call.
It’s a very serious possibility that you could lose your job if you don’t execute well.
Conclusion: Take the Error-Free Route
Whether you have 1 lease or 1,000+ leases, the experts agree the calculations behind the compliance data are extremely complex. You must prioritize the integrity of your data.
There’s no room for human error.
In practice, compliance approaches that depend on manual processes for individual reporting pose major risks.
And while 60% of public companies took this advice and implemented lease accounting software for compliance, 47% of private companies have decided spreadsheets and other manual methods are the best route to go.
Add to this the fact that 77% of private company executives say their organizations are only somewhat prepared or unprepared for compliance, and you’ve got the perfect ingredients for financial misdemeanors.
On the other hand, software that ensure accuracy, consistency and accessibility will give companies a leg up on implementation and help avoid any unwanted surprises and disruptions. In fact, companies that onboarded lease accounting software experienced less mistakes, less headaches, and less financial repercussions than those that didn’t.
If you’re one of the thousands of private companies with an implementation deadline of January 1, 2021, we’d recommend checking out our software today. It’s fully compliant, easy to use, and comes with a team of experts to help with every step.