Recently, the Financial Accounting Standards Board (FASB) issued its long-awaited, new lease accounting standard update, ASU No. 2016-02, Leases (Topic 842). This ASU affects the financial statements of companies that lease real property, equipment, vehicles and other fixed assets.
Here are four things public companies need to know to implement and be compliant with the new standard:
1. Companies must prepare before the effective date
For public companies, the new standard applies to fiscal years starting after December 15, 2018 (including interim periods within those years). The ASU requires a “modified retrospective” transition, so your company must apply the new rules to leases existing at, or entered into after, the beginning of the earliest comparative period presented in your financial statements for the adoption year.
To ease the implementation burden, the ASU doesn’t require transition accounting for leases that expire before initial application of the new standard. You can also elect certain “practical expedients” that streamline the identification and classification of pre–effective-date leases and certain other accounting decisions.
2. Balance sheets will grow
Under the new standard, your company must recognize a “right to use” asset and a corresponding lease liability on your balance sheets for all leases with terms longer than 12 months. Both the asset and the liability will be based on the present value of minimum payments under the lease. The asset is subject to adjustment, such as for initial indirect costs.
This significantly departs from current Generally Accepted Accounting Principles, which require capital leases to be recognized on the balance sheet but permit off-balance-sheet treatment of operating leases (with appropriate disclosures). Because most leases today are operating leases, the new standard is expected to cause many companies’ balance sheets to grow substantially.
The FASB believes that, by including operating leases on the balance sheet, it will be easier for financial statement users to compare companies that lease their productive assets with those that own them.
3. Lease classification still matters
Although all leases will be treated similarly on the balance sheet, the new standard makes a distinction between operating leases and “finance” leases (similar to today’s capital leases) for purposes of reporting expenses on income statements. Operating leases will result in straight-line recognition of rental expenses (similar to current practice). However, for finance leases, your company will amortize the right-to-use asset (usually on a straight-line basis) and separately recognize interest on the lease liability over the lease’s life. This is likely to result in front-loaded expense recognition, similar to a mortgage, with higher interest expense in the lease’s early years and lower interest expense in later years.
The FASB’s dual model approach differs from the single model approach taken by the International Accounting Standards Board in its recently released lease standard. As a result, lease accounting will be a challenge for some multinational companies. (See sidebar: “Spotlight: Do leasing arrangements require two sets of books?”)
4. Loan covenants and key performance indicators may be affected
Evaluate the potential impact of the new lease accounting standard on loan covenants. By substantially increasing lease liabilities on balance sheets, the new standard may cause some companies to violate loan covenants that place a cap on total debt or require the borrower to maintain a certain debt-to-equity ratio. Talk with your lender about modifying your loan agreements’ definition of “debt” or adjusting the permissible ratio.
Assess the new standard’s impact on key performance indicators. This is particularly true for those that are used to calculate performance-based compensation.
As the FASB’s implementation date approaches, review your leases — including contracts with lease components — to assess the impact of the new standard on existing and future leases. Also evaluate your systems, processes and internal controls to ensure that you’re prepared to gather and record the necessary information.
Finally, educate investors about the new standard’s impact on financial statements. Even though the underlying economics won’t change, investors may wonder why your company’s balance sheet has grown substantially larger without an increase in shareholders’ equity.
The four points above may not be the only things a public company needs to implement. I recently gave a presentation on the new lease accounting standard update to the West Los Angeles CalCPA meeting, which takes a deeper dive into ASU No. 2016-02. You can view the slides from that presentation here. For more information on how to implement changes required by ASU No. 2016-02, contact Vaibhav Tandon, Audit and Accounting Manager, at 310-828-9798 or firstname.lastname@example.org.