Accounting Standards Update 2016-02 necessitates companies to record assets and liabilities associated with operating leases in financial position statements. Unlike capital leases, operating leases include transferring the right of use of a property from the lessor to the lessee without moving the risk and reward associated with the property to them (Paik, 2015). On the other hand, capital leases comprises the transfer of the risks and rewards of leased property, plant, and equipment to the lessee from the lessor. Initially, the Financial Accounting Standards required companies to record capital leases in the statement of financial position without providing such guidelines regarding the operating leases' assets and liabilities (Dhaliwal et al., 2011). Companies now need to record their operating lease right to use assets and obligations in the statement of financial position. Firms that will continue to use the conventional metrics, including 'return on assets' after the accounting standards updates, will begin to experience critical changes that will seem to alter their business forms misleadingly.
The update will also force companies to invest in new accounting software that incorporates the changes stated above. The accounting standards update has rendered some accounting information technology obsolete, forcing all firms to update their software or procure new ones (Dhaliwal et al., 2011). Discussions on the acquisition of new technology by the firm are not complete without considering other related costs, such as training employees on using the technology resource and maintenance costs. The impact of the standards updates on accounting also impacts auditing procedures to be used by both external and internal auditors. The change sees auditors thinking on internal control procedures surrounding leases and compliance tests involving the standards update. The change will increase uniformity in lease-related accounting across all firms. Furthermore, the update is expected to increase transparency in lease-related accounts.
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Impact of the Standard on the Reporting of Microsoft Company's Leases
Microsoft Inc. will start recording operating' leases, assets, and liabilities in its statement of financial position and the associated incomes and expenses in the profit and loss statement. Such assets, initially disclosed in the accountant's notes, will no longer require any disclosures (Sec.gov, 2020). Instead, Microsoft will recognize them under the 'right to use assets' in the balance sheet's current assets section. In return for using the leased assets, the company ought to compensate the lessor through rental payments. Such obligations are recorded in the current liabilities section of the balance sheet (Sec.gov, 2020). The specific amounts of the operating lease obligation are calculated as the discounted value of all future payments the company will pay for exploiting the leased property or equipment. By calculating the present value of all future lease payments, Microsoft can also determine the amount of invested capital. Microsoft determines a constant cost of debt to discount the future lease payments to its present value. Furthermore, recognizing the lease assets in the balance sheet calls for the calculation of the depreciation costs related to such assets.
Microsoft calculates depreciation on a reducing balance or straight-line basis after considering the assets' useful life (Sec.gov, 2020). Microsoft Inc. then records the depreciation amounts. Generally, the accounting standards update 2016- 02 affects Microsoft's calculation of invested capital, Net Operating Profit After Tax, enterprise value, and the shareholders' value.
Impact of Lease Concessions and Modifications on Microsoft Leases Reporting
Lease concessions refer to a reduction in lease payments, which may include reducing lease rent by some amount, deferral of the rent payments for some years, or change in the nature of rent payment (Cotton et al., 2013). Lease modification refers to the changes in terms of the lease contract, including the scope of the lease and the considerations for the lease. Lease concessions are forms of lease modifications, with their accounting treatment being somewhat complex. Lease concessions require lessees to re-compute lease obligations using adjusted discount rates and revise their right to use assets.
Microsoft Inc. identifies two forms of lease modification; change in lease consideration and reduction in the scope of the lease. According to Microsoft, a change in lease consideration refers to a reduction in the rent payments, while reducing the scope of the lease refers to a decrease in the lease term or even the termination of the lease contract (Cotten et al., 2013). Other aspects, such as changing the payment type from fixed payments to variable payments, are also considered by Microsoft management accountants. The company recalculates its new obligation, revalues the right of use asset, and adjusts its balance sheet to reflect these revised amounts ( Sec.gov, 2020). The new lease obligation measure is the discounted value of future payments at a revised discount rate or lease term. The company also revalues the leased asset on the occasion of reduced lease term or termination of the lease contract. The gain or loss on the partial or full termination of the lease contract is then reflected in the company's statement of profit and loss.
Impact of ASU 2016-02, Leases on Microsoft' Financial Ratios
The accounting standards update 2016-02 on leases affect financial statements, including final assets, liabilities, depreciation, amortization, and capital, consequently affecting accounting ratios associated with these aspects (Scott, 2016). The debt-to-equity ratio is the first ratio likely to be affected by the accounting standards' changes. Due to the recognition of operating lease current assets and liabilities in the statement of financial position, there will be an increase in these balance sheet figures, affecting the overall debt to equity ratio.
Second, the need to calculate depreciation of the newly recognized right to use asset will increase Microsoft’s depreciation expense, affecting the company's earnings before interest, tax, depreciation, and amortization. The operating lease has to be amortized during the lease term, and an amortization schedule even drafted. The amortization amounts on the amortization schedule are recorded as the annual depreciation figures of the lease assets. On the other hand, the interest component of the lease portrayed in the amortization schedule is an interest expense, affecting the company's earnings before interest, tax, depreciation, and amortization (Scott, 2016). However, the company's earnings before interest, tax, depreciation, and amortization will remain the same despite the updated accounting treatments on leases due as amortization expense is offset by interest expense as stated above.
Finally, the fixed charge coverage ratio will also be affected by the accounting standards update on leases. The new accounting treatment will affect the company's cashflows. A company's cashflows determine its liquidity and its ability to service its loans. The new accounting treatment impact on debts, lease expense, and interest expense implies that the fixed charge coverage ratio is altered. The company has to make its leveraging decisions based on the new fixed charge coverage ratio.
References
Cotten, B., Schneider, D. K., & McCarthy, M. G. (2013). Capitalisation of operating leases and credit ratings. Journal of Applied Research in Accounting and Finance (JARAF) , 8 (1).
Dhaliwal, D., Lee, H. S., & Neamtiu, M. (2011). The impact of operating leases on firm financial and operating risk. Journal of Accounting, Auditing & Finance , 26 (2), 151-197.
Sec.gov. (2020). Retrieved 17 December 2020, from https://www.sec.gov/Archives/edgar/data/789019/000156459018019062/msft-10k_20180630.htm .
Paik, D. G. H., van der Laan Smith, J. A., Lee, B. B., & Yoon, S. W. (2015). The relation between accounting information in debt covenants and operating leases. Accounting Horizons , 29 (4), 969-996.
Scott, L. (2016). New FASB Rule Challenges Financial Institutions and Loan Customers . Claconnect.com. Retrieved from https://www.claconnect.com/resources/articles/new-fasb-rule-challenges-financial-institutions-and-loan-customers .
