“What do you do when it rains?"
The captain answered frankly. "I get wet.”
― Joseph Heller, Catch-22
The forecast is in: Private companies may see their valuations decline as a result of FASB ASC 842 compliance...or lack thereof.
Not exactly what you want to hear at the beginning of a new year.
Nor is it what you expect to happen when you’re conducting business as usual, simply following the rules--as in the new lease accounting standards--and doing your best to be in compliance by the new 2021 deadline.
The good news is that you’re not alone. When it comes to FASB ASC 842 compliance, all private companies face the same catch-22:
Implement the new lease accounting changes to avoid non-compliance and penalties. And consequently face the negative impact reporting under the new standards could have on your company’s valuation.
It doesn’t seem fair.Actually, fairness is a major reason why the boards saw the need to update the old standards. Previously, companies weren’t required to disclose their liabilities regarding operating leases on their balance sheets.
These off-balance sheet obligations represented a hefty number only recorded in the footnotes of income statements along with the payments for their corresponding assets.
As far back as 2008, Sir David Tweedie, former chairman of the International Accounting Standards Board, quipped about the inequity of this loophole saying that his lifelong ambition was to someday fly in an airplane that was actually on an airline’s balance sheet.
The point of his wish is coming true.
The new lease accounting standards, FASB ASC 842, IFRS 16 and GASB 87, along with recent accounting reforms, aim to make company accounts more transparent across the board, thereby presenting a more complete financial picture of each and every organization.
So what has changed?
Operating leases move to the balance sheet.
The new guidance calls for virtually all leases, finance and operating, with terms greater than 12 months to be reported on the balance sheet. And we’re talking all types of leases--for property, plant, vehicles and equipment.
Embedded leases come out of hiding.
Contracts or service agreements with vendors often contain components which give the user control over the asset--like a copier or other piece of office equipment. These arrangements, known as embedded leases are now also required to be recorded on the balance sheet.
New name for capital leases.
What used to be called a capital lease under ASC 840 will now be referred to as a finance lease under ASC 842. All leases are classified as finance leases under IFRS 16 and represent long-term debt on financial statements.
Bright lines disappear.
Instead of being rule-based like the old guidance, the new lease accounting guidance is principles-based and removes the bright line percentages that defined “a major part of the economic life” and “substantially all” for the fair market value of an asset.
A fifth test added to determine finance leases.
The four questions used to determine lease classification remain in the new standards, but another one has been added. This fifth “alternative use” test questions how highly specialized a leased asset is.
Because companies will have to create a complete lease inventory and collect pertinent data in order to implement the lease accounting changes, opportunities exist to streamline processes and improve forecasting and budgeting.
But there’s also the possibility for companies to “get wet in the rain” of compliance.
If it looks like debt...
Where operating leases used to be unreported liabilities, under the new lease accounting standards, they will need to be recorded much the same way capital leases under ASC 840 previously were reported--as assets and liabilities.
So leases will have a greater impact on your financial statement than in the past.
For example, the ROU asset amortization is calculated as the difference between the straight line rent and interest for the specific period; an amortized cost basis is used to account for the liability. Adding these two expenses together gives you the lease expense to record on the balance sheet.
When all these liabilities are taken into account, the total represents a significant value showing up for the first time in the financial statements, creating obligations that, if not actually considered debt, are certainly debt-like.
Financial Restatements on the Rise?
With the deadline for compliance on the horizon, there’s not much time for companies that haven’t already begun the transition to file with the absolute confidence that their financial statements are accurate and error-free.
The new lease accounting standards require complex calculations and numerous data points that you probably haven’t tracked before now. Rushing through the implementation process, omitting even one lease that should be included or a miscalculation--even a typo--could mean you need to file a restatement.
And predictably, market value drops when a company refiles.
No matter what the reason.
The Ripple Effect
The formal admission that previously filed financial statements were inaccurate could mean your company experiences an unwelcome series of repercussions.
- A lower credit rating.
- A change in loan terms.
- A potential sale falling through
Conclusion: Lease accounting software to the rescue
Many parts of the implementation process--gathering leases, creating an inventory, etc.--require hours of human input. And classifying leases, creating your internal controls, policies and procedures, and determining specific measurement details also depends on human judgement and reasoning.
And while achieving compliance is certainly humanly possible, spreadsheets and other manual methods won’t cut it if your company has more than a handful of leases.
Successful implementation takes time, a dedicated team with meticulous attention to detail and a systematic approach to analyzing lease data and making the complex calculations required for reporting.
An accurate, error-free report is the goal.
In addition to reducing the risk of errors inherent with manual methods, lease accounting software offers improved accessibility, reliability and consistency by:
- Performing critical calculations
- Storing lease data in a centralized location
- Standardizing the way assets are accounted for
- Ensuring data is up to date
- Providing standard and customized reporting
- Tracking changes made to lease terms
- Simplifying the auditing process
To minimize the risk of refiling and all the ensuing implications of a restatement (and possibly a valuation hit), consider an automated solution that’s supported by a team of lease accounting experts with over 20 years of industry experience. If you’d like to talk or set up a demo, we’re here to help.