Lease Accounting Changes Impact on Systems
By now, the joint project of FASB (Financial Accounting Standards Board) and the IASB (International Accounting Standards Board) to converge U.S. and international lease accounting standards is inevitable. The objectives of the proposed standard to include more transparency, eliminate off-balance-sheet obligations, and provide a faithful representation of leasing transactions are clear. However, the proposed changes will affect the value of the operating leases as they become capitalized and added to a company’s balance sheet both as an asset and a corresponding liability. The current rent payments will be replaced with implied interest and amortization expenses on the income statements. Therefore, metrics like EBITDA, net income, and cash flows from operations will be dramatically affected. This, in turn, might shift the dynamic between lessee and lessor as lessees might opt for shorter lease terms and purchase assets instead.
Business process changes are expected in the areas of finance and accounting, IT, legal, tax, operations, corporate real estate, and HR. In addition, the system implementation costs for the lessors have been a major concern for financial institutions especially when the proposed standard suggests requirements to be applied to existing leases as well. Given we are at the stage where feedback are being considered, a final standard issuance is unlikely to take place before 2014 and not likely to come in effect before 2017. However, because there is no grandfathering, preparers will need to apply the guidance to all leases existing as of the beginning of the earliest comparative period.
Here are the two major system changes we expect from the lessor side:
Payment and Residual expected to be reported separately – Traditional leasing software has payment amortization and residual amortization combined into one calculation as defined by current accounting standard. The new accounting change will require a separate payment amortization schedule and a residual accretion schedule for accounting and reporting purposes. This means significant customizations required to break out those fields and calculations. Fortunately, NetSol LeasePak solution is built with the foresight of choosing the combined option or the independent option. For us, it’s a matter of setting the “Accrete Residual” field to “Y” and the calculation will be generated separately.
Using an example of a lessor manufactures, a machine for $7,500 with a fair value of $10,000 and enters into a three-year lease with an annual payment of $2,400 paid at the end of the year, residual asset at the end of the lease term at $4,770, and 7.87% IRR.
A traditional combined schedule will be reflected as:
The new accounting standard will require the calculations to be broken into:
New fields required– Because of the changes, new fields will be required to be displayed. Some of them include:
- Cost of Asset
- Present Value of Lease Payments
- Carrying Value of Asset [(Cost of Asset x PV of Lease Payments) / Asset Fair Value]
- Profit at Commencement [PV of Lease Payments – Carrying Value of Asset]
- Gross Residual (PV of Estimated Future Value)
- Net Residual [(Cost of Asset x Gross Residual) / Asset Fair Value]
- Deferred Profit [Gross Residual – Residual Asset]
These are some system changes that will impact existing leases and any new lease when the accounting changes become ratified. At NetSol, we work closely with our customers regularly in anticipation to these changes. We understand the business impact and we are here to help minimize the costs and provide a smooth transition.
By Farooq Ghauri, COO, NetSol Technologies North America