The U.S. and international accounting boards (FASB and IASB, respectively) have finalized new standards that will have a significant impact on how leases will be reflected in financial statements going forward.
For the S&P 500 alone, this will be a $1.5 trillion event.
Companies following GAAP or IFRS will be required tp adopt the standard for fiscal years beginning Jan.1, 2019, and financial statements issued in 2019 will include a “look-back” for two prior years, to 2018 and 2017. Companies will have the option to begin reporting new standards as early as 2018, if they desire. Private companies can delay the change in reporting until fiscal year 2020. There will be no grandfathering of any leases – all leases in existence beginning on this date will be on the balance sheet.
These changes will significantly alter how leases impact a company’s financial statements, but the impact of these changes will also affect many areas of corporate life outside of accounting, including corporate real estate, internal controls, information systems and operations. Some of the most critically important issues every CFO must understand include the following:
- Despite serious efforts to achieve a “converged” standard between FASB and IASB, the new standards are not fully converged. The most significant difference between the FASB and IASB new rules is the IASB rules use one “model” for accounting for all leases, while the FASB standards utilize a “duel model” approach – these two models have very different financial statement impacts.
- By virtue of the fact that the liability balances will almost always be greater than the asset balances, the impacts to balance sheet metrics are material, and include the following:
- Reduction to shareholder equity
- Debt-to-equity and current ratios reduced
- Reduction to regulatory capital, such as Tier 1 capital for banks
- In many instances, renewal options, and other options, will significantly alter the P&L impact from a given lease, and those impacts could include either a worsening or an improvement of net income or EBITDA, or both. This will be triggered if significant economic incentives exist. These incentives are a new, subjective judgment test which must be applied consistently by a corporation.
These changes will affect essentially everyone – public, private, nonprofit, governmental, etc., any entity reporting financial results on a GAAP or IFRS audited basis.
The changes not only impact how leases will be accounted for but will completely change the way leases must be negotiated on a go forward basis. Lease negotiations and lease drafting run real risks of major unintended consequences on financials. There are highly subjective issues that can create material differences in financial results. Leases with identical cash flows can hit balance sheet differently and when they hit balance sheet differently, they hit P&L differently.
Corporate real estate departments need to be actively engaged in this transition and will likely co-lead this transition process with their accounting departments. This will likely change the way many corporations choose to structure leases, M&A activities and other transactions.
For a successful transition, consider these four steps:
Step One: Conduct a strategic review of your lease portfolio in order to (A) begin building a framework around your firm that will deal with the more subjective issues in these news standards, including topics related to “significant economic incentives” in renewal and termination options, evaluating a property’s remaining economic life, and (B) quantify and understand the way in which a representative sample of your leases would be reflected on your financials under these new rules.
Step Two: Get systems and technology upgraded so you can capture the data needed. This will be a joint effort by corporate teams from real estate, information technology, equipment leasing, finance and accounting.
Step Three: Get internal operating teams and systems aligned for functional integration and expanded workload.
Step Four: Update corporate strategy regarding financing decisions, operating requirements and real estate decision making.