What the new lease accounting rules mean for your company
The new rules will affect your organization if you lease anything from copiers to office space. The new rules provide guidelines on lease accounting that represents the most significant change to lease accounting rules since capital and operating leases were differentiated forty years ago. The driving force for this change was to move U.S. GAAP towards International Financial Reporting Standards (IFRS), part of the various convergence initiatives including revenue recognition.
Where the new guidance is coming from
In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842), requiring all lessees to recognize the following for all leases (with the exception of short-term leases) at the commencement date: a lease liability, which is a lessee‘s obligation to make lease payments arising from a lease, measured on a discounted basis; and a right-of-use asset, which is an asset that represents the lessee’s right to use, or control the use of, a specified asset for the lease term. For public companies, the ASU is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. Thus, for a calendar year company, it would be effective January 1, 2019. For all other organizations, the ASU is effective for fiscal years beginning after December 15, 2019 and for interim periods within fiscal years beginning after December 15, 2020. Early application will be permitted for all organizations.
Most small business have the attitude that “I’ll worry about it when it’s effective.” Your organization cannot wait until the last minute to try and determine the impact. Lessees must apply a modified retrospective transition approach for leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements. The new lease accounting requirements will require companies to go back through their lease agreements to find data that was previously not relevant for accounting purposes. This could be a challenging task as most companies keep their lease schedules offline in excel spreadsheet and will need to modify those spreadsheets in order to do the required calculations and provide the additional disclosures necessary.
Leases will still be separated into two types of leases with different accounting treatment but those leases will both show up on the balance sheet and will be classified as follows:
Finance Lease – This type of lease and related criteria is similar to current U.S. GAAP accounting for capital leases.
Accounting Treatment – A lease obligation liability is recorded at lease commencement date by calculating the present value of future lease payments using the lease’s stated interest rate or the organization’s incremental borrowing rate. The liability will be reduced by each payment made on the lease. A corresponding right-to-use asset is recorded on the asset section of the balance sheet at the lease commencement date. This asset is amortized through the life of the lease term by reducing the right-to-use asset on a monthly basis and recording amortization expense on the statement of operations. Interest expense is accrued each month on the lease obligation using either the stated rate or the organization’s incremental borrowing rate.
Operating Lease – the previous operating lease arrangements disclosed in the financial statements will now be presented on the balance sheet.
Accounting Treatment – Similar to the Finance Lease, a lease obligation liability is recorded at lease commencement date by calculating the present value of future lease payments using the lease’s stated interest rate or the organization’s incremental borrowing rate. The liability will be reduced by each payment made on the lease. A corresponding right-to-use asset is recorded on the asset section of the balance sheet at the lease commencement date. Unlike a Finance Lease, there will be no explicit interest and amortization component presented on the statement of operations. The monthly expense will be considered “lease expense” for presentation purposes. The monthly expense will be recognized evenly on a straight line basis over the term of the lease.
A majority of leases in the past have been intentionally structured as operating leases to avoid tripping debt-to-equity ratios. This has led to criticism that operating leases are a large source of off balance sheet financing. The new lease accounting standard will create new liabilities on company balance sheets and will affect debt covenants that may be based on debt-to-equity ratios. We recommend companies do the modeling well before implementation and have a discussion with their bankers early on about the impact of the standard and get the debt-to-equity covenants reworked.