With leases shifting to the balance sheet as liabilities, the standards may affect debt and loan covenants and creditor relationships.
With the new standards, you must include most leases on the balance sheet and report them as right of use assets and lease liabilities. Depending on the standard that applies to your organization, there are differences in the impact of how lease liabilities are classified on the balance sheet. The classification may increase the liabilities to the point where debt covenants may be impacted. For ASC 842, there may be minimal impact, since operating leases are considered operating liabilities, and not debt. However, in the approach that the IASB took for IFRS 16, it’s possible that lease liabilities might be classified as debt, which could affect the debt covenants. Debt covenants should be reviewed and possibly updated, or waivers may need to be obtained, given that lease liabilities are now on the balance sheet.
Assess the number and value of leases to be included on the balance sheet and determine the impact on financial ratios.
Assess the existing debt covenant thresholds and guidelines. Evaluate if there are any protections against changes to financial ratios due to shifts in standards.
Lenders need to assess the impact the standards will have on their customers. The lender’s staff needs to understand the standards and their requirements.
A critical new factor for understanding lease liabilities, the Incremental Borrowing Rate (IBR) may be a new metric for you, causing you and your accounting team to look to Treasury or your bank to calculate this properly.
Calculating lease liabilities for the leasing standards requires you to use the interest rate implicit in the lease. The implicit interest rate of a lease is rarely provided to the lessee and is not that easy to figure out, as certain lessor inputs are needed which are not generally known. The standard provides a practical expedient where the implicit interest rate is not determinable and that is the Incremental Borrowing Rate (IBR). Virtually all organizations use the IBR instead.
The IBR is the interest rate a lessee would have to pay to borrow the value of the asset over a similar term length on a collateralized basis.
Figure out your corporate borrowing rate, considering the currency, economic environment, and the term of the loan, and make any necessary adjustments, such as for security and asset type.
If there isn’t a corporate borrowing rate, use a borrowing rate for an index or similar industry, and adjust it for your organization.
Non-public companies also have the option of electing to use a risk-free rate, rather than an IBR estimation. A period comparable with that of the lease term must be used for the rate and the rate must be applied to the entire lease portfolio.*
Work with your bank or the Treasury team to calculate the IBR or consider a risk-free rate since they will have the existing rates easily available.
*Organizations that elect to use the risk-free rate must disclose this election as well as the class of underlying assets to which the election has been applied. Those who are considering becoming public will be required to revert to IBR when public, requiring retrospective estimations of the IBR.
The standards require taking a fresh look at lease and non-lease components.
One of the most challenging aspects of the new lease accounting standards is the requirement to separate lease and non-lease components. If you’re familiar with the new standard, you’ll know that there is an optional practical expedient to not separate the components that can be elected by asset class. However, there are some pros and cons to taking the practical expedient that you should consider before deciding.
How will you define the asset classes for which you elect the expedient? Keep in mind that the asset class categorization must be kept constant across all accounting standards.
If you choose not to separate components, how much greater will the right-of-use asset and lease liability be with the addition of non-lease components?
If you choose to separate, how will you track critical variables for valuing the components, like standalone observable prices?
Use the right approach to determine whether a contract contains a lease or not.
The way you define leases changes under the latest lease accounting standards, ASC 842, GASB 87 and IFRS 16. Most leases are no longer referenced in footnotes but are reported on the balance sheet. Under ASC 842, leases still need to be classified as operating or finance. In many instances, lease identification will remain unchanged from the previous standards. However, the new lease definition does change the identification of some leases.
Does a contract contain an embedded lease? Is there an identified asset in the contract? Who controls the asset? Is the asset substitutable? Who gets the economic benefits from use of the asset?
Does a contract meet the term length of the lease definition? If it is shorter than 12 months, is there reasonable certainty that it will be renewed? Are there cancellable periods in the contract?
Do the assets meet materiality thresholds? Typically, these are assets less than USD$5,000 in value but companies may have their own threshold defined internally and approved by the auditors. Will materiality be applied at an asset or contract level?
The standards may affect an organization’s Lease vs. Buy strategy given the balance sheet changes.
The lease versus buy analysis has always been a crucial way for you to determine which option will suit your organization the best. The new leasing standards require additional reporting for certain types of leases compared to the previous standards. However, many of the same financial benefits and drawbacks as before are still present and should be considered in your decision making process.
What are the cash flow needs of the organization? What kind of down payment would purchasing an asset require? What kind of payments would leasing the asset require?
How will leasing assets impact financial metrics compared to purchasing the assets? Consider Return on Asset and debt covenants.
Is the asset likely to become obsolete in a few years? Consider computers, medical equipment, and other technology-based assets.
Most of the requirements of the standards affect lessees, but some may have an impact on lessors. Sometimes lessees become lessors as well.
While the new lease accounting standards will have larger implications for lessees than lessors, lessor lease accounting is impacted. Lessors also need to be aware of how the new standards impact their customers and how the standards may change customer leasing preferences.
How are variable payments accounted for differently under the new standards?
How are lessors affected by the new rules governing sale leaseback transaction accounting?
Is lessor software updated to accommodate the new accounting standards for their customers?
As deadlines continue to come into focus, the options for transition and practical expedients have also changed.
The transition from ASC 840 to ASC 842 and from IAS 17 to IFRS 16 can be challenging. However, there are options that can help alleviate some of the burden of bringing all operating leases onto the balance sheet, including expedients and software technology.
What are the pros and cons of the expedients for specific leases? Consider costs, whether leases will be classified differently under the new standards, and whether the new standards could act beneficially on the balance sheet.
How do different valuation options impact the accuracy of the asset measurement?
Can an option be applied lease-by-lease, or must it be applied to all leases?
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