The most dominant topic for the past 5 years within the capital accounting space has been the pending, and now officially mandated, requirements for leasing. It’s taken the two governing accounting bodies FASB & IFRS several years to agree on a standard and stick to a timeline but the requirement is now here and must be dealt with.
Before we cover this change in the leasing requirement and the resulting SAP impacts, let’s first review what the requirements are.
Where did this all start?
The standards regarding leasing were previously covered by IASB under IAS 17 and by FASB under ASC 840. IAS 17 dates all the way back to 1980 (as Exposure Draft E19 “Accounting for Leases”) and covered the appropriate accounting policies and disclosures required for lessees and lessors related to finance and operating leases. This last point is a key one because one of the main components of the lease accounting standards was the proper classification of the lease; is it an operating or finance/capital lease? For a finance lease, the lessee is required to put the finance lease information on their balance sheet. This was not the case for operating leases. Operating lease information could be disclosed via footnotes in the financial statement. Most importantly, the lessees were not required to add the lease’s financial values (both asset and liability) to their balance sheet. After all, they didn’t own the property or equipment so why should it be on the company’s balance sheet? ASC 840 had the same treatment.
IFRS 16 and ASC 842 change this. Lessees are now required to maintain their operating leases on their balance sheets. They have to recognize both the asset (i.e., value of the equipment being leased) and liability (contract value) of the operating lease as if they owned it. They must also report depreciation and interest separately. This change to disclosing the total balance sheet value of operating leases is definitely the biggest difference between the old and new approaches to lease accounting.
Why make the change?
The reason that the change was made was, in part, because of the degree that companies were using financing and leasing for operational purposes. Companies were taking advantage of the financial flexibility that leasing offers and were leasing assets to a degree that hadn’t existed previously. After all, it’s cheaper than buying. Without having detailed financial information on the leases, external parties couldn’t accurately analyze companies or compare them to others. By requiring that lease information be brought onto the balance sheet, it improves the transparency of a companies financial statements and makes comparisons easier.
What are the impacts
Why is this a big deal? Well, companies will now have to bring a massive amount of assets and liabilities onto their balance sheet. This is sometimes referred to as expanding the balance sheet.
How much is expected? IFRS itself estimates that around $3 trillion of leases will be added to companies balance sheets as a result of this change in practice.
CNBC agrees and is trying to educate individual investors about the change. These changes impact the calculations investors use to define a companies leverage which is a key measure when evaluating a company’s risk.
The key question is how are SAP customers going to address this? We’ll start going over the options in the market next.