FINANCIAL WATCH By Gary Anderson, Kyle Elken, Jeff Lezinski Considerations for the Implementation of the New Lease-Accounting Standard: System Application Impacts Part Two of a Three-Part Series This series of articles focuses on some of the expected challenges and impacts of the new lease-accounting standard and early planning steps that may reduce implementation costs. Part One (in the January/February issue) looked at lessors’ internal considerations (operations, staffing, accounting policies, education, underwriting and evidence to support key estimates in inputs). Part Two expands the discussion to identify factors to consider for accounting and servicing systems’ impact from the change. Part Three will focus on customers’ (lessees’) new requirements and needs. Please note: The effective date of the standard is the reporting period following December 15, 2018 for U.S. public companies. Prior year comparative data are required: balance sheet year-end 2018 and income statements full year 2017 and 2018. IT MODIFICATIONS AND SYSTEM CHANGES Initial Direct Costs The new rules modify the definition of Initial Direct Costs (IDCs) associated with lease contracts, but not loan contracts. Under the new standard, IDCs for lease contracts will be limited to incremental third-party costs that would not have been incurred were it not for the lease being executed, whereas IDCs for loans will continue to include internal origination costs. From a systems perspective, this may ne-cessitate some modifications as some systems automatically calculate IDCs (e.g., overhead) for contracts based on formulas. Systems may need to be updated to comply for the change applicable for lease con-tracts but not for loan contracts. In addition, the new rules require that IDCs be included in the implicit rate calculation of the lease thereby making IDC a compo-nent of the initial net investment. Systems today may include several types of yield calculations on lease contracts, some calculating the implicit interest rate in the lease without IDC and some involving other blended calculation components. Going forward, users of lease-accounting systems will need to ensure that the application calculates an implicit rate that includes IDCs (strictly under the new definition). Begin with understanding the new requirements. The first article in this series discussed the importance of understand-ing the new accounting rules across the business in order that the full impact of change is understood. Having those discussions in group settings will help foster agreement and commitment to the changes necessary to implement the new standard. Consider whether there are other system applications that also need modification such as a separate front-end system or pricing tool. You should also consult with your software provider(s) to understand what version the up-grade modification will be applied to and whether that is compatible with your version in use. If you are operating on an older version, your upgrade path may be more complicated. Define the changes that need to be made from old rules to new rules. Agree to the changes internally as a business, which may include confirmation with a separate GAAP standards group and/or internal audit. You should also seek your external auditor’s confirmation on your interpretation of the new rules. Balance Sheet Presentation of Guaranteed Residuals Guaranteed residuals, including lessee guarantees in split-TRACs and synthetic leases as well as third-party guarantees like residual value insurance, are currently presented as a part of lease receivables. The new rules will classify them as residuals. This will entail mapping changes in systems. Identify the leasing software application requirements to address the new rule changes. Once you have the new rule change requirements identified, seek con-sensus with your software provider and, if available, its user group community. Your software provider will likely be gathering multiple change requirements from across its customer base and will then seek to level set or balance those change requirements, enabling them to de-sign a single change upgrade. You should review the software provider’s change design and confirm it addresses your requirements. You should also review the delivery schedule and compare it to your timeline needs in consideration of upgrade testing, user training and implementation. POTENTIAL CHANGES Following are some examples of the potential changes lessor software application systems may need. (Note: These are illustrative examples and are not inclusive of all the potential changes software systems may require.) 50 MARCH/APRIL 2016 EQUIPMENT LEASING & FINANCE MAGAZINE Sales-Type Leases and Residual Value Insurance Currently, certain lessors structure lease contracts (where FMV is not equal to carrying cost) to obtain sales-type lease treatment by purchasing Residual Value Insurance (RVI) enabling the classifica-tion to flip from an operating lease to a sales-type finance lease. This allows for upfront recognition of gross sales-type profit vs. straight-line rent revenue. Topic 842 will no longer permit upfront gross sales recognition under this strategy because such arrangements will no longer be allowed to be classified as sales-type leases; they will still however be permitted to be classified as a direct finance leases. Many current lease-accounting systems perform lease classification tests under Topic 840 and classify contracts as finance or operating leases