This article was updated on Sept. 6, 2018.
The Financial Accounting Standards Board (FASB) issued new lease guidance on February 25, 2016, in response to criticism that the previous lease accounting did not provide the users of financial statements with a faithful representation of leasing transactions. ASU 2016-02 Leases (Topic 842) is effective for calendar year public entities in 2019 and for other entities in 2020. The new lease guidance is expected to impact businesses of all sizes and will affect financial statements, lease negotiations, financial ratios, debt covenants and processes.
It may sound like you have a lot of time before you have to start worrying about this new guidance, but in reality you need to be thinking about this and how it will affect your business now.
What Does the New Guidance Require?
In a nutshell, if the lessee is leasing an asset under an agreement with terms greater than 12 months, he or she is required to recognize an asset and a liability on the balance sheet. Previously, only capital leases were recognized on the balance sheet.
Does an Arrangement Contain a Lease?
Gather the documentation you have and start analyzing these contracts with the help of your attorney. The first step is to determine if the contract is or contains a lease. The standard defines a lease as a "contract, or part of a contract, that conveys the right to control the use of identified property, plant or equipment (an identified asset) for a period of time in exchange for consideration."
What is the right to control the use of an asset? This requires judgment but generally constitutes the economic benefits of using the asset and the ability to direct its use.
Once you determine you have a contract that contains a lease, you are then required to classify the lease as either a finance lease or an operating lease using the following criteria:
- The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
- The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.
- The lease term is for the major part of the remaining economic life of the underlying asset.
- The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments equals or exceeds substantially all of the fair value of the underlying asset.
- The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.
If any of the above criteria is met by the lessee, the lease is a finance lease. If none are met, the lease is an operating lease. It's a good idea to get your accountant involved in this analysis to see what kind of leases you have.
It's important to note that you have to look beyond the contract lease term and consider any noncancelable periods. For example, if you have a lease term of 10 months with an option to extend for another six months and you are reasonably certain that you will extend, then the lease term (from an accounting perspective) is actually 16 months. So it will be crucial to get your operations folks involved in this analysis, in addition to your accounting team.
Once you know you have a lease and you have classified it, the next step is to consider how to account for the lease.
For both a finance lease and an operating lease, the right of use asset is recognized on the balance sheet, in addition to a lease liability at the present value of lease payments not paid.
The difference comes on the income statement. In the case of a finance lease, you will amortize the lease and interest expense. The interest expense is front-loaded with constant amortization expense, and the impact on your profit or loss will be higher at the beginning of the lease term than at the end. You will have a straight line rent expense for an operating lease.
Impact of the New Accounting
A company's balance sheet will now have an asset and a liability for leases that were previously only disclosed in the notes to the financial statements. This will impact ratios such as working capital, current ratio, quick ratio and debt to equity. Lenders who look at these financial statements will see different ratios that could impact the cost of borrowing. This will also impact established covenants under debt agreements.
What Should You Be Doing Now?
This is the time to get the different departments in your company involved in gathering information to analyze how this new guidance will impact you.
- Gather information on all existing lease arrangements currently recorded on the balance sheet, and see how these may be impacted by the new guidance.
- Look through other agreements to identify leases that were not previously recorded on the balance sheet, and apply the new guidance to see how it impacts your financial statements.
- Look at systems and controls in place to make sure the correct information is capable of being captured. This could involve looking at existing software capabilities.
- Consider the impact the new guidance has on financing situations and any applicable loan covenants. Now is the time to start having conversations with bankers about the potential impact and any necessary changes in the wording of agreements as needed.
- If you have leases that are up for renewal or are discussing new leasing arrangements, consider the impact of the new guidance as this may impact your lease negotiations, as well as impact lease vs. buy decisions.
- As you are entering new leases, start to capture and track the information that will be required under the new guidance to stay ahead of the requirements.
The new guidance is here and will impact companies of all sizes; we will see virtually all leases being recorded on the balance sheet as a result. The impact is beyond financial reporting. It will affect existing systems, processes and important business decisions. Take the time now to assess the situation and discuss the potential impact with your service providers. That way you can come up with a plan for successful implementation and manage the effect on your business. When in doubt, consult with your own accounting professional for advice specific to your business.
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