How to effectively implement the new lease accounting standard

The new lease accounting standards—ASC 842 lease accounting for U.S. GAAP and IFRS 16 for international reporting—are a significant change for companies, lessors, and investors alike. Staying compliant while ensuring your financial reporting is accurate and transparent is crucial. In this guide, we’ll walk you through the essentials of implementing these changes, from understanding the key updates to deploying the right tools.

The new lease accounting standards: what’s changed?

The new lease accounting standard introduces major shifts in how leases are reflected on financial statements. Previously, companies could keep operating leases off their balance sheets. Now, all leases must be recognized, with a right-of-use (ROU) asset and a corresponding lease liability.

Who is affected?

1. Lessees: Organizations with substantial lease portfolios will need to revamp their reporting processes. This change impacts assets, liabilities, and equity on the balance sheet.
2. Lessors: Updates around income recognition and asset management are key for maintaining accurate financial records.
3. Investors & Analysts: Changes to accounting treatment require a revaluation of financial ratios and metrics, which could impact perceptions of an organization’s financial health.

Preparing for implementation

What resources are needed?

To ensure a smooth transition, companies will need to update their lease data management processes for accurate calculation of ROU assets and lease liabilities. Key steps include:

• Time and effort from finance teams to support the transition.
• Training and upskilling employees on the new standard.
• Implementing lease accounting software to automate processes and reduce manual errors.

How long will implementation take?

The timeline can vary, with smaller organizations seeing quicker rollouts, while larger entities, especially in sectors like retail or real estate, may need more time due to complex lease portfolios.

How to build your lease inventory

A comprehensive lease inventory is essential for compliance. Here’s what to focus on:

What defines a lease?

A lease is any agreement that grants the right to control an identified asset for a period of time in exchange for payment. This includes:

• Identified assets: Clearly outlined or implied in contracts.
• Control of use: The ability to determine how the asset is used and derive economic benefits.

Steps to create a lease inventory

1. Collect documents: Gather all lease agreements—operating, finance, and even those embedded in service contracts.
2. Categorize leases: Classify them by asset type, noting renewal options and payment schedules.
3. Centralize data: Use a lease management system to ensure ongoing accuracy and compliance.

Lease Classification & Measurement

How to classify leases

Leases are categorized into either finance or operating leases based on criteria like:

• Ownership transfer: Will the ownership transfer at the end of the lease term?
• Reasonably certain purchase options: Does the lessee intend to exercise purchase options?
• Lease term: Does the term cover a significant portion of the asset’s life?
• Present value of payments: Do lease payments approximate the asset’s fair value?
• Asset specificity: Can the asset only be used by the lessee?

New measurement guidelines

Lessees must recognize both an ROU asset and lease liability on their balance sheet:

• ROU asset: Calculated as the present value of lease payments, adjusted for direct costs and incentives.
• Leasel: The present value of unpaid lease payments, discounted at the lease’s implicit rate or the lessee’s borrowing rate.

Calculating ROU assets and lease liabilities

For initial recognition of ROU assets:

• Sum lease payments (fixed + variable based on index).
• Add any initial direct costs.
• Subtract lease incentives.
• Discount payments using the appropriate rate.

For lease liabilities:

Consider total lease payments, including both fixed and variable, plus any residual guarantees, and apply the correct discount rate.

Transitioning existing leases

Available transition options

There are two primary approaches to transitioning existing leases to the new standards:

• Modified retrospective approach: Recognize existing leases as of the transition date.
• Practical expedient: Skip the reassessment of certain contracts or exclude short-term leases.

Expired leases during transition

Leases that expire during the transition period are handled based on their remaining term. Leases that expired prior to the transition date may not need to be recognized, while active leases must comply with the new standard.

The role of technology and software

Adopting the right software is critical to staying compliant and making the transition smoother. An effective lease accounting solution ensures you can calculate ROU assets and liabilities, apply the proper discount rates, and maintain transparent reporting.

Key features for lease accounting software

• Centralized lease management: Maintain a comprehensive, up-to-date record of all leases.
• Automated ROU calculations: Streamline calculations and eliminate manual errors.
• Discount rate application: Accurately apply the relevant interest rates for your leases.
• Compliance-ready reporting: Ensure the software delivers the necessary reports and audit trails for financial transparency.

Evaluating your lease accounting software

When choosing the right software, consider:

1. Comprehensive features: Ensure the solution covers all your needs, from lease tracking to compliance.
2. User-friendly interface: Look for an intuitive platform that your finance teams can easily navigate.
3. Integration capabilities: Choose a solution that seamlessly integrates with your existing financial systems for consistency and accuracy.

Updating financial reporting processes

Changes to financial statements

There will be several changes to how your financial statements are presented:

• ROU Assets: Must be recognized under non-current assets.
• Lease liabilities: Presented as current and non-current liabilities, based on the payment schedule.
• income statement adjustments: expenses will need to reflect lease classification.

Strengthening internal controls

Conduct an audit of your current lease processes to identify any compliance gaps and ensure that your policies and procedures align with the new standard. Ongoing training and internal controls updates are vital to maintain accuracy and transparency.

Training and communication

Proper training and communication are key for successful implementation. Here’s who needs to be trained:

• Finance teams: Focus on technical changes such as lease classification, measurement, and reporting.
• Legal and procurement teams: Help them understand how new lease terms will affect reporting.
• IT teams: Ensure seamless software integration and utilization.
• Management & auditors: Prepare them for strategic decisions and compliance impacts.

Communicating with stakeholders

Establish clear communication with stakeholders to explain the changes and their impact on financial reporting. Consider holding information sessions to ensure everyone understands the new requirements and their implications.

Overcoming common implementation challenges

At MRI Software, we’ve helped numerous organizations transition seamlessly to the new lease accounting standards. Common challenges include:

• Data management: Gathering accurate lease data from multiple departments can be a struggle. A centralized lease management system can simplify this.
• Resistance to change: New systems and processes can face pushback. Comprehensive training and change management strategies can help mitigate this.
• Resource constraints: Smaller teams or limited budgets can slow down the process. Automated lease abstraction can ease some of these resource issues.
• Complex lease agreements: Complex terms or embedded clauses can complicate classification. AI-powered lease abstraction can parse these complexities and streamline the transition.

Best practices for data accuracy

To minimize data errors and ensure a smooth transition:

• Conduct a thorough lease inventory: Gather all lease data upfront to avoid omissions or errors.
• Use centralized lease management systems: Simplify data management and ensure consistency across the board.

Perform regular audits: Conduct regular data audits to check for discrepancies and ensure ongoing compliance.

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