As standalone regulations, revenue recognition (IFRS 15 and ASC 606) and lease accounting (IFRS 16 and ASC 842) are each challenging in their own right. Revenue recognition completely overhauled the way organizations account for contracts with customers and lease accounting put over $3 trillion worth of lease obligations onto the balance sheets of organizations. Both regulations required overhauls to data, systems, and processes.
But for some organizations, the intertwining of these regulations adds an additional layer of complexity. Any company which sells a bundled offering which includes granting the customer use of a physical asset may have to account under both the revenue and leasing standards for a single contract – taking each standard into account when addressing the other. Examples of impacted companies may include organizations that sell mobile phones, set-top boxes, photocopiers, medical equipment, and vehicles.
How to approach the interaction between lease accounting and revenue recognition
For public companies, the effective dates for both regulations have passed but that doesn’t mean companies are not looking to refine their compliance processes to further automate and increase efficiencies. And private companies still have a bit more time to comply with the lease accounting standard.
So how should organizations think about the interaction between the standards?
The first step is to determine whether contracts contain an embedded lease, which is a lease that is hidden within a wider contract. Once these embedded leases are identified across a contract portfolio, the Standalone Selling Price (SSP) for each component and/or performance obligation in the contract must be identified to determine how much of the revenue should be accounted for under the revenue recognition standard. Any line items that represent a lease need to be accounted for under IFRS 16 or ASC 842.
This allocation of revenue can be quite complex and can vary throughout the life of a contract. This is particularly true in cases where there are multiple assets or service components which can each vary in number during the contracted period alongside other provisions such as minimum spend clauses.
An illustration of how this plays out in practice
A large medical device company leases a variety of technologies including pre-fillable syringes and infusion systems. They also offer services like drug packaging design and access to device and scientific testing experts. A typical contract may offer 10,000 infusion systems filled with 50,000 units of a specified drug. In addition to these lease and consumable components, the organization is also providing pre-clinical services for a new drug the lessee is bringing to market. The infusion systems will be provided up front and over the course of the year the lessee can draw up to another 10,000 units of the drug with a minimum guaranteed spend of $50,000 with an additional option to increase the number of infusion systems.
Under revenue recognition, the product and services lines must be separated, and each given a Standalone Selling Price and the revenue accounted for correctly. The leased line items, the infusion systems, are embedded in the larger contract and must be pulled out and accounted for accurately under the lease accounting standard. If, midway through the contract, the lessee changes the quantity of items or the price shifts under a new offer or minimum spend clause, the allocation changes and this alters the accounting for the contract under both standards. When you multiply this example across thousands of unique contracts, the complexity is clear.
Compliance vs. management reporting
Despite the financial accounting requirements being determined by two different standards, finance professionals want to understand balance sheet and P&L impacts holistically by contract, business line, or other business segment.
So, from a management reporting and business analysis perspective, the challenge is to be able to view the contracts in a unified manner, and on a consistent basis, while still adhering to the financial reporting requirements. This is where challenges can arise when compliance activities are performed using a highly manual approach or in separate systems that prevent the ability to see and analyze profitability at the contract level.
How can organizations with this cross-over challenge remove complexity?
With an automated solution that addresses both revenue recognition and lease accounting requirements, the organization can meet compliance while maintaining the ability to drive insights through analytics done at the contract level.
At Aptitude, we've provided solutions to help CFOs address regulatory challenges, including revenue recognition and lease accounting, for over 20 years. To learn more about how we can help you address your compliance challenges, please reach out to firstname.lastname@example.org. You can also check out our upcoming webinars on the topics.