With new lease accounting standards set by the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) nearing the deadline, many are still racing to comply. The new standards will fundamentally transform the rules that govern accounting for nearly all lease types. The changes are expected to have far-reaching implications for accounting, financial planning and reporting, real estate portfolio management and tax compliance. Especially impacted will be technology that supports lease accounting, such as financial management software.
Compliance at a glance
With a few exceptions, the new rules require that operating leases appear on the balance sheet as an obligation and a related right of use (asset). Some believe this could make IASB Income Statements much more volatile in the future. This is due to the front loading of Interest Expense. Both standards will have a substantial impact on an organisation’s debt/equity and other ratios, which could have an adverse effect on a company’s overall credit worthiness. According to some estimates, the new lease accounting rules could add as much as £60 billion to the balance sheets of companies in the UK.
Looking beyond the deadline
As companies race to comply with IFRS 16 and ASC 842, much of the focus has been on the obstacles and pathways to compliance. Businesses are working to centralise, validate and augment existing lease data to ensure completeness and accuracy, and to procure a software solution that can classify, record, remeasure, transition and report in compliance with the new standards.
The challenge is compounded by the fact that most accounting teams have been focused on ASC 606 (Revenue Recognition) and are now rushing to procure systems for what is quickly becoming a table stake commodity of functionality as software companies also race to develop fully functional solutions.
But what happens next? Once the dust settles, a greater emphasis will be placed on strategic real estate actions that help mitigate the impact of recording operating leases on the balance sheet and with new regulations, finance has a bigger role and seat at the table for those discussions.
Many companies with large operating lease portfolios will see their recorded assets and liabilities increase by more than double. Investors will be paying attention to metrics such as ‘Return on Asset’ and ‘Debt to Equity,’ which will not fare well for organisations that are not looking to optimise their portfolio performance in parallel with lease compliance activities.
Organisations that are using a comprehensive real estate management software solution should be able to count on tried and true space management and utilisation functionality along with lease and compliance to target the worst offenders and take action.
Getting strategic about lease liabilities
From a finance perspective, it’s all about making the most of the real estate portfolio given the amount of liabilities you have leased and the assets you hold. Once you’re compliant, it’s time to think about how to best manage the liability to drive more favourable balance sheet ratios, such as debt-to-equity, and ensure your organisation isn’t carrying more debt than necessary.
Shifting attention to focus on more efficiently and proactively managing your portfolio requires addressing occupancy and understanding how best to use the space. The more efficient you are with leased space, the less of an adverse impact it has on your balance sheet.
You can start by identifying which leases have the highest exposure on financial statements and evaluate the business units that occupy them, how densely those spaces are populated and how they’re being used.
If you use multiple systems to capture lease, space and other building information, you won’t have the necessary insight across all disciplines in real estate management to make the best decisions.
Using technology
In the quest to overcome this challenge, many businesses are moving from multiple systems to a single solution that captures lease, lease compliance, space and other building information.
This type of solution can help accurately and efficiently manage disparate data across the real estate lifecycle and deliver high integrity insights that help identify cost savings and efficiency in other areas such as maintenance and space management. In this case, you’ll have space utilisation, lease agreements, occupancy costs, maintenance costs, user data and other important information in a centralised solution for a single source of truth and 360-degree view of the entire portfolio.
With this in place, you can quickly understand available options and proactively manage your portfolio to ideally lessen the lease liability on your balance sheet.
Using the space effectively
As attention turns to more efficiently and proactively managing the portfolio, the focus should shift to occupancy and use of space. The more efficient you are with space, the less of an adverse impact it has on the balance sheet. This means your business requires less space, lowering the occupancy cost per square foot/meter and as a result, reducing liability. It will also reduce operating expenses reported in your income statement.
It’s a well-known fact that on average, office workspace density is between 40 and 60 percent. If we look on the low end of this spectrum, this means that at any given time, most businesses are only using half of their leased space. If a building is not being used properly, there may be ways to reduce costs. An example is consolidating under-used space, adopting a more flexible working strategy or even subleasing a floor.
Where to start?
Evaluate which leases are causing the biggest problem. Find out when they are up for renewal and begin to evaluate these options for lowering that liability:
- Is there an option to move people from other business units into that building and consolidate other buildings nearby that may be nearing their lease expiration?
- Is the space under-used? If so, can you consolidate the under-used space into a defined area or floor so that you can then sublet that space? This will shift the space from a cost to a revenue opportunity and also off-set CRE costs – both of which will improve your balance sheet. This alone with deliver a return on your investment in technology.
- Is the market ideal for you to sublet? Looking at market data can help evaluate if the market is ripe for this option. Maybe you can sublet a floor for more than you are paying per square foot/metre.
- Is there a buyout option on the lease?
- Is there an opportunity to terminate the lease early? This may involve a short-term penalty but could result in a long-term gain.
Embedding compliance with strategic thinking
As you race to meet the deadline for IFRS 16 or ASC 842 compliance, it’s important to give consideration to long-term effects of the new standards. Incorporating strategic technology and tools will deliver benefits well beyond simply satisfying auditors. The resulting savings, revenue opportunities and positive impact on your balance sheet alone will deliver a rapid return on your investment in technology and position you not only for compliance, but for a successful and efficient workplace.