Is your business ready to adopt the new lease accounting standards? Are you equipped to handle the added complexity of recording lease obligations on your balance sheet? Discover effective strategies to prepare in advance and smoothly implement the new standard with minimal impact.
In the wake of the updated lease accounting standards, companies are quickly realizing that the new lease standard will require much more time and resources than originally anticipated. The shift to new standards, such as IFRS 16 and ASC 842, requires companies to recognize nearly all leases on the balance sheet, which adds a layer of complexity to financial reporting. The new lease accounting standards not only impact on how leases are recorded but also affect key financial metrics, compliance with lender covenants, and internal systems used for lease management. In this article, we’ll explore how these changes affect your business, why preparation is critical, and the steps you can take to ensure smooth implementation.
What Is the lease Standard Change?
Under the new lease accounting standards, the most notable change is the requirement for companies to recognize both operating and finance leases on the balance sheet. Prior to these updates, many leases—specifically operating leases—were kept off-balance sheets, which helped companies maintain a stronger-looking balance sheet and financial ratios.
With the new rules in place, businesses will have to recognize:
- Right-of-use (ROU) assets: Representing the lessee’s right to use an asset over the lease term.
- Lease liabilities: Reflecting the present value of lease payments due under the terms of the lease agreement.
This adjustment can significantly change a company’s financial position, increasing both assets and liabilities, which can affect key financial ratios such as the debt-to-equity ratio and return on assets (ROA). The changes also impact financial covenants, potentially triggering breaches if covenants were set based on metrics such as leverage or interest coverage ratios.
For companies with many leases, this could present an increased risk of non-compliance, unless proper steps are taken early in the process.
What Are the Potential Issues with Applying the New Lease Accounting Standards?
First, the new lease accounting standards also introduce a significant increase in complexity when it comes to managing lease data. Companies will need to gather detailed information on all lease contracts, including lease terms, payment schedules, renewal options, discount rates, and more. For businesses with a large portfolio of leases, managing this data manually can be an overwhelming task. Accurate and up-to-date lease data is critical not only for complying with the new accounting standards but also for making informed business decisions. Many companies find that their existing systems, which were sufficient for tracking basic lease information, are no longer adequate for the increased volume and complexity of data under the new rules.
This is where technology can be a game-changer. Implementing a robust lease management system that integrates with your enterprise resource planning (ERP) and accounting software is crucial for ensuring compliance. These systems can automate key processes such as tracking lease terms, calculating liabilities, and generating the required disclosures. Without the right technology in place, your company risks significant delays, errors, and compliance issues.
The new lease accounting rules demand more from businesses—an advanced lease management system is now essential to meet compliance and drive operational efficiency.
Moreover, the new lease accounting standards will also have a direct impact on key financial metrics and performance indicators. For example, metrics such as EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) could see substantial changes. Under the new standards, lease expense is split between depreciation of the ROU asset and interest expense on the lease liability, which can affect profitability and cash flows differently than before.
As a result, your company’s financial statements and KPIs will look different under the new standard. If your company has debt covenants tied to specific financial ratios—such as leverage, interest coverage, or return on assets—there is a risk that these ratios could be negatively impacted by the recognition of lease liabilities on the balance sheet.
It is important to assess how these changes could impact your relationships with lenders and investors, especially if your company is near threshold limits on certain financial covenants. Communication and renegotiation of covenants may be necessary to ensure compliance, and it’s a good idea to work with your lenders early in the process to understand how the new lease accounting standards may affect your borrowing capacity.
The new lease accounting standards could reshape your financial landscape by impacting EBITDA, altering key performance indicators (KPIs), and shifting how lease liabilities and ROU assets are reported—putting a spotlight on the need for proactive communication with lenders to protect your financial ratios and borrowing capacity.
How to Prepare for the New Lease Accounting Standards?
To ensure your business is prepared for the changes and minimize disruption during implementation, consider taking the following steps:
Conduct a Lease Inventory
Review all your company’s lease agreements, whether they are operating or finance leases. This includes all leases—both written and unwritten—that your organization is involved in. Ensure that the terms and details of each lease are fully documented. This may require looking beyond the finance department and working with procurement, legal, and other teams to collect all relevant information. While this process can be time-consuming, it is crucial to have a comprehensive understanding of your lease obligations. Don’t forget to include related party leases, which may often be overlooked.
Assess Your Technology
Evaluate your current systems for lease management and accounting. If your current system isn’t equipped to handle the new standards, it’s time to invest in lease accounting software that integrates with your financial system. Many lease accounting solutions are designed specifically to handle the complexities of IFRS 16 or ASC 842, making them an essential tool for compliance.
Identify Embedded Leases
Embedded leases are maintenance, service, or other contracts that contain lease elements, such as the use of specified assets. Under the new standards, these agreements must be treated as leases and capitalized on your balance sheet, which may not have been required under previous standards. Locating and accounting for these embedded leases can be challenging, but it is essential to ensure full compliance.
Review Financial Ratios and Covenants
Work closely with your finance team to understand how the new standards will impact your financial metrics. If you have outstanding debt covenants, engage with your lenders early to discuss potential changes. Being proactive will allow you to avoid any surprises when your financial statements are prepared under the new rules.
Engage with External Advisors
Given the complexity of the new lease accounting standards, it may be beneficial to work with external advisors, such as auditors or lease accounting consultants, to ensure your implementation plan is comprehensive and aligns with regulatory requirements.
Conclusion
The new lease accounting standards, while necessary for greater transparency, introduce a significant amount of complexity and require careful planning for successful implementation. The impact on your financial statements, key metrics, and covenants with lenders should not be underestimated. The key to success is preparation, and by getting ahead of the curve, your business will be well-positioned to navigate the changes and leverage the new standards for long-term success.
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