How Will the New Lease Accounting Rules Impact You?
12 Potential Business Risks of Lease Accounting that CEOs Should Pay Attention To
Trillions of dollars in new leases will appear as assets and liabilities on the balance sheet in the next few years as a result of the new lease accounting standards. With these new assets and liabilities, various financial metrics could change significantly for some companies, potentially impacting business relationships with shareholders, bondholders, lenders, and credit rating agencies. Determine the business risks that your company may face once you implement the new standards.
Top 12 Business Risks from Lease Accounting
#1) Market Capitalization
Market capitalization is determined in part by equity, which could change under the new accounting standards. This change could be significant for large companies, who will have billions of dollars rushing onto the balance sheet. If your company has a large leasing portfolio, it’s critical to consider how these changes could affect your share price and market capitalization. If you report under both IFRS and US GAAP, remember to check how each standard impacts equity, as it could be different. Read this equity analysis by The CPA Journal to learn more.
#2) Credit Ratings
Credit Ratings agencies, such as Moody’s, Fitch, and Standard and Poor’s, should already factor in off-balance sheet leases. Moody’s stated that it expects no major impact on credit ratings. However, many companies don’t even know how much they actually lease, so the credit ratings agencies may be off in their estimates. Start determining your leasing obligations now, so that you can be prepared if there is a disparity between the actual value and what the agencies say.
#3) Borrowing Ability
Many businesses are worried about what will happen as new lease liabilities are transferred onto the balance sheet. Will it increase the debt on your balance sheet? Could that in turn hurt your ability to borrow money in the future? Will it impact your ability to raise new debt? One comfort is that FASB has said lease liabilities will be reported as operating liabilities rather than debt. However, you should still address the impacts of these changes with your lenders so they are not surprised when your operating liabilities balance jumps up.
#4) Debt Covenants
FASB treats lease liabilities as operating liabilities rather than debt, and IFRS does not define terms like debt. As a result, the accounting bodies feel that there won’t be an extreme impact on debt covenants. Even so, you should check the terms of your existing debt covenants. Ensure that the increase in liabilities won’t break them or violate any terms. Reach out to your banks and bondholders so that they are aware of the new standards, and how the changes will affect the liabilities on your balance sheet. Read this article from Moss Adams to learn more about how debt covenants are affected.
#5) Financial Metrics
Certain financial metrics will almost certainly be impacted by the influx of assets and liabilities to your balance sheet. In addition, metrics related to the income statement will also change under IFRS 16. It’s important to determine how your metrics will change now. Some companies may adjust how they measure their own performance. Others will change the metrics they promote to investors and bondholders. Learn how some of the most widely-used financial metrics are impacted.
#6) Executive Compensation
Executive compensation is often based on financial metrics. One commonly used metric for this calculation is EBITDA. EBITDA will increase under IFRS 16 (though not under ASC 842). Find out what financial metrics are used for calculating executive compensation at your company and how those will change under ASC 842 and IFRS 16. Depending on the severity of the change, you may need to adjust how your company determines executive compensation. Read this IFRS analysis on how IFRS 16 will affect EBITDA and other metrics.
#7) Equipment Leasing
There has been some speculation that the new accounting change will influence companies to stop leasing equipment because the administrative costs and hassles of compliance exceed the benefits. Instead, they may choose to purchase traditionally leased equipment like forklifts, trucks, and computers. A study by KPMG found that on average, companies expect the new standards to have a moderate impact on their lease v buy decisions. However, the same benefits of equipment leasing still exist, so companies should always conduct a lease v buy analysis to weigh the advantages and disadvantages. They can then consider whether the cost of the stricter reporting requirements outweighs the benefits they would receive from leasing. Learn more about the lease v buy process.
#8) Real Estate Leasing
A traditional leasing bias has existed in real estate decisions. With the new accounting standards, there are questions about whether that bias will disappear and companies will instead choose to own their office buildings, warehouses, and retail stores. However, like with equipment leasing, you should always conduct a lease v buy analysis, so that you don’t throw away savings by choosing the less financially advantageous option.
#9) Capital Requirements
Capital requirements are closely monitored for financial institutions. The new leasing standards could negatively impact their capital ratios. Off-balance sheet liabilities are not currently incorporated when calculating capital requirements. When lease liabilities transition onto the balance sheet, financial services institutions may have to adjust the capital they hold. Read this article from Thomson Reuters on how capital requirements will be affected.
#10) Investor Relations
Investors will gain more insight into your leasing activity under the new standards – that’s a big part of the reason FASB and IASB chose to update the standards in the first place, according to an article in Forbes. Investors will be interested in how your financial metrics change, but they’ll also want to know that your leasing program operates efficiently. They’ll want to know if your company has good processes in place to evaluate the most cost effective option to procure the assets. They’ll want to know if you are seeking out the most competitive financing terms like you would with any other purchase or debt transaction. Make sure you standardize your leasing processes and can justify your acquisition decisions.
#11) Material Weakness
Auditor scrutiny will increase under the new standard. They could find fault with the current lease accounting that public companies provide. Many companies don’t have an accurate understanding of their lease portfolios – a PwC survey found that 39% of companies described their leasing program as “decentralized” and many may have absolutely no information on their smaller leases. To avoid problems with audits post implementation, find out today whether the leasing obligations your company discloses in the annual report are really accurate, or if they have been poorly tracked and under (or over) stated.
#12) Reporting Burden
For large companies, complying with the new accounting standards will require a major effort. This could be another Sarbanes-Oxley-type situation with massive administrative burdens not only for the accounting department, but for every department that touches leasing. A 2017 study by PwC found that 76% of companies rate the data collection process as somewhat difficult to very difficult. You should begin work now to identify how many leases your company has. As you implement the standards, start standardizing your leasing process so that you can more easily track leases in the future. Learn more about the data collection process.
Most Risks are Well Understood
The new lease accounting standards have been under development for over 10 years. As a result, the business risks from lease accounting are well understood by most of the institutional investors (think pension funds, mutual funds, insurers) that are shareholders in Fortune 500 companies. Banks that offer credit are also aware of these changes, as many banks sell leasing products of their own.
As a result, most experts on the new lease accounting standards believe that most professional investors have factored the accounting change into their financial models over the past few years. Of course, that does not rule out the possibility that there could be surprises.
Most experts on the new lease accounting standards believe that the majority of companies will not change their leasing behaviors. Accounting treatment is just one of many benefits of leasing. Of course, this does not rule out the possibility that there could be a few surprises.