New Guidance on Lease Accounting Forces Companies to Assess Financial Impacts
Previous lease accounting method criticized for failing to meet the needs of users of financial statements and for not always being a faithful representation.
Beginning after December 15, 2018 for public companies, and after December 15, 2019 for private entities, Accounting Standards Update (ASU) 2016-02 (aka Topic 842) will require all firms with operating leases of greater than 12-month terms to report these leases on their balance sheet. Leases entered after the effective date will not be classified as leveraged leases. The choice of lease classification could have a significant impact on a firm’s financial statement.
An operating lease is one where the lessor is only obligated to pay the contracted rentals, and is not necessarily obligated to purchase the asset upon lease termination. With the new standard, the lessor will experience less impact than the lessee, but must also comply with the new revenue recognition standards. In addition, the expectation is that most real property leases will become operating leases (e.g., 10-year rental term in a building with a 40-year life).
Previously, the operating lease model received heavy criticism because it only required a schedule in the audit footnotes and did not always provide a faithful representation of leasing transactions. This failed to meet the needs of financial statement users. As a result, investors pushed for a method of reporting lease transactions that provided more transparency and more opportunity to compare company financial statements. Footnote disclosures will continue to be required, but with more detail.
The recognition of operating leases will have the most dramatic impact on financial statements. The rule now stipulates that a lessee must record a lease liability that is equal to the present value of all lease payments made. For example, if you are expensing operating leases on your income statement, such as copiers or office rent, the new standard will require you to record a liability for the lease obligation and an offsetting asset on the balance sheet.
Capitalized leases, as defined by the new standard, will now be referred to as finance leases. Since finance leases contain assets that are leased for most of their useful lives, the Financial Accounting Services Board (FASB) expects that a high percentage of personal property leases will become finance leases.
With the new standard, all leased assets will become right-of-use (ROU) assets on the balance sheet with a corresponding lease liability. An ROU asset is calculated by taking the initial measurement of the lease liability, adding any payment amounts made before the lease start date, and subtracting lease incentives received and direct costs incurred by the lessee.
Impacts of the new lease standard on financial statements are numerous. In addition to having another asset and liability on the balance sheet, expensing of operating leases (including the interest) will be done on a straight-line basis and recorded on the income statement as a single line item under Lease Expense. Expenses for finance leases are more front-loaded (i.e., expenses decline over time). The interest expense on the lease liability and the ROU asset amortization will be recorded as separate line items on the income statement. Lease liabilities and ROU will be presented in a similar fashion to a loan with a current portion and long-term portion.
Other areas that may be dramatically impacted by the new lease standard are financial ratios and loan covenants, to the point where bank covenants may need to be renegotiated. Loan covenants maintaining certain debt-to-equity and current ratios may also be affected if a company has been using operating leases to fund equipment purchases. In this case, depending on whether financial ratio covenants exist, some renegotiation may be required.
Now is the time to analyze the impact the new lease standard will have on your balance sheet, and to educate your lender. The good news is that you have some time to review your capital expenditure planning, your use of operating leases, and any financial covenants you may have. By doing a thorough pro-forma analysis based upon your current use of operating leases, you will be one step closer to meeting the future challenges posed by ASU 2016-02.
Depending on the number of lease-related assets your company records, the number of assets to be tracked could increase significantly. It may benefit your organization to investigate automation technologies, such as Fixed Assets, from Bloomberg Tax. This will afford you the flexibly to accurately calculate depreciation and amortization on the life of each asset and easily perform what-if scenarios to aid in critical decision making.