By: Jeff Goudie
While companies are hard at work preparing the Financial Accounting Standards Board’s (FASB) new revenue recognition rules (effective for public companies in 2018), the effective dates for the new lease accounting rules contained in the FASB’s Accounting Standards Update (ASU) No. 2016-02, Leases (Topic 842), and the International Accounting Standards Board’s (IASB) International Financial Reporting Standards (IFRS) 16, Leases, are not far behind.
These rules are complex and quite intricate, and companies that do not begin to prepare soon may find it difficult to comply in a timely manner. Those organizations that use Dynamics 365 understandably will need both an integrated solution, and regulatory and technical guidance from their Microsoft partners.
The new rules
Under the existing standards, lessees generally account for a lease based on its classification as a capital (or finance) lease or an operating lease. Lessees recognize capital leases (e.g., lease of equipment for nearly all of its useful life) as assets and liabilities on their balance sheets. Operating leases (e.g., of office or retail space for 10 years) are not recognized on the balance sheet, and appear in financial statements only as a rent expense and disclosure item.
According to the FASB, most lease obligations are not recognized on the balance sheet, and transactions often are structured to achieve off-balance sheet treatment.
ASU 2016-02 will require lessees to recognize assets and liabilities for substantially all leases with terms of more than 12 months, regardless of their classification. The right to use the leased asset will appear on the balance sheet as a right-of-use (ROU) asset. The obligation to make future lease payments – discounted to their present value – will be a liability. A lessee’s recognition, measurement, and presentation of expenses and cash flows arising from a lease generally will continue to depend on its classification as a finance or operating lease. The ASU places a new emphasis on management judgment regarding a lease to determine its proper classification.
In light of the new rules, companies will need to keep at least two sets of books, and quite possibly four, in 2018. Currently, companies reporting under US generally-accepted accounting principles (GAAP) will need to show the earlier comparative periods presented on financial statements as if ASU 2016-02 were always in effect. Those that also must report under IFRS 16 will need to keep one set of books under the current standard (International Accounting Standards 17, Leases), and another under the new standard if they choose the full retrospective transition method.
Public business entities must adopt ASU 2016-02 for interim and annual periods beginning after Dec. 15, 2018. All other organizations will need to comply for annual periods beginning after Dec. 15, 2019, and for interim periods beginning a year later. IFRS 16 requires compliance for all organizations in 2019, with early adoption allowed in certain circumstances.
Implications for companies
Under the current standard, many organizations take a “set and forget” approach to their operating leases. Such an approach will not work for US GAAP purposes once ASU 2016-02 takes effect.
To begin with, lessees will need to inventory all of their leases to determine many key terms that have not previously been tracked, including lease term, likelihood of renewal, and whether lease payment amounts are tied to an index.
Lessees also must identify the nonlease components in their leases (that is, goods and services provided to the lessee separate from the right to use the leased asset). For example, a company that leases a photocopier under an operating lease currently records the expense on its income statement, with no recognition on its balance sheet. Under the new standard, companies can separate the lease component (the amount paid for use of the copier) from the nonlease component (the amount paid for toner, paper, maintenance, and insurance). Only the lease component should appear on the balance sheet.
In addition, the loading of the balance sheet with new lease-related assets and liabilities could have far-reaching effects. For example, the new reporting rules might affect financial ratios and therefore affect debt covenants, executive compensation, and other items tied to ratios. Moreover, organizations might determine that it makes more sense to buy instead of lease in some cases. Generally, if the implicit rate in a lease is significantly higher than the incremental borrowing rate, the leased asset is a strong candidate for purchase.
These and other considerations mean that few organizations will find compliance preparation to be a quick task. Companies need to budget appropriately and determine whether they have adequate internal resources in terms of capacity and expertise in both the accounting standards and the risks associated with Dynamics ERP integration.
The software situation
Clearly, many organizations will need to develop processes and controls to collect the necessary lease information, which, for some companies, is spread around the world. Spreadsheet-based models that have been sufficient under the current standards will fall short in light of new tracking requirements.
This is why we recommend that organizations using Dynamics 365 turn to their Microsoft partners for regulatory and technical guidance. Companies can rely on Dynamics 365 to tackle some of the more rudimentary aspects of compliance under the standards, such as updating the chart of accounts, making ledger entries, and uploading data, but users will need to add on to Dynamics 365 to fill some gaps. For example, external applications will be required to do the following:
- Calculate schedules, such as future lease payment, lease liability amortization, and ROU asset depreciation
- Classify leases as operating or finance based on management’s judgment
- Manage lease information (for example, commencement date and transfer of ownership options)
- Generate journal entries for the initial recognition and subsequent measurement of lease liabilities and ROU assets
- Calculate balance sheet impact
- Control lease data integrity
- Manage contract documents
Companies reporting under US GAAP must take care not to amortize their operating lease ROU assets using the fixed-asset module of their system because ASU 2016-02 does not follow the straight-line method of depreciation.
Companies that wish to develop an in-house solution using Dynamics 365 for lease accounting compliance will need to keep several considerations in mind. For GAAP purposes, an organization should develop several new accounts, including interest expense on finance lease liabilities, amortization on finance lease ROU assets, operating lease expense, and finance lease variable costs (where lease payments change based on an index, the company must track those variable expenses separately from interest and amortization). Companies also should consider tracking their lease executory costs in separate accounts, such as taxes and common area maintenance.
On the IFRS side, the chart of accounts structure must be redesigned to capture the proper information for financial reporting, including a separate chart for interest expense on finance lease liabilities and amortization expense on ROU assets. These accounts should be properly mapped to the cash flow statement financing activities for principal payments, and the interest can be either financing or operating activities depending on the company’s policy. From a managerial reporting perspective, it is recommended companies use separate accounts to track lease expense in terms of cash outflow independently from their interest and amortization.
At year-end, when creating IFRS financial statements in the management report, companies may need to generate two sets of financial statements, one for operations and one for financial reporting. The financial statements for operations will use the lease expense account to show lease cash outflows from a managerial perspective, and those for financial reporting will use the interest and amortization account.
The new lease accounting standards could have substantial impact on a company’s financial statements and accounting processes. Organizations, therefore, should launch their compliance projects sooner rather than later. Dynamics 365 users can add on to the program to smooth the way.