Changes to Lease Accounting
In February of 2016, the Financial Accounting Standards Board (“FASB”) issued an Accounting Standards Update (“ASU”) 2016-02, Leases, which significantly changes the way leases are accounted for on the financial statements of lessees. The ASU also includes changes to accounting for leases in the financial statements of lessors to conform and align with the new revenue recognition guidance. The new lease accounting standard is a result of the FASB wanting more transparency and comparability among companies by requiring all leasing arrangements to be recognized on the balance sheet as a lease asset and a lease liability in the financial statements of lessees. This essentially means that any company under current accounting standards that have operating leases, which are considered off-balance sheet financing, will now be required to record those leases as a Right of Use (“ROU”) asset and a corresponding lease liability, as the entity has a right to use the underlying asset for the lease term. Additionally, there are going to be increased disclosures in the notes to the financial statements to further increase transparency.
Did the FASB Change the Definition of a Lease?
The definition of a lease remains unchanged, however the FASB does give explicit guidance on what defines “control” and what defines an “identified asset” under the new standards. An “identified asset” must be detailed in the lease agreement and the supplier must not have substitution rights. If the supplier has substitution rights, it would not meet the definition of an “identified asset”. The criteria for “control” is the lessee must have the right to direct how the asset is used and they receive substantially all the benefits from the asset.
Lessee vs Lessor Accounting
The new lease accounting standards will bring substantial changes to the way lessees account for leases. Under current accounting standards, the lessees have two lease options, capital leases which are capitalized on the balance sheet and operating leases which are recorded through the income statement. The new lease accounting standards will require all leases to be recorded on the balance sheet, with the only exception to this is if the lease term is less than 12 months or the agreement does not meet the definition of a lease, in which case, the lessee is able to make an accounting policy election not to recognize the lease assets and lease liabilities. Lessees will still have two options for categorizing their leases; financing leases, which are essentially the same as capital leases, and operating leases, which will be recorded on the balance sheet as a ROU asset and a lease liability.
Lease accounting for lessors are similar to current accounting standards. The modifications made to the accounting for leases from a lessor perspective were made to align the new lease standards with the new revenue recognition standards. The change focuses in on whether the lease agreement transfers ownership of the asset, which is a key principle in the new revenue recognition standards.
The new lease standards are effective for fiscal years beginning after December 15, 2018 for public companies and for fiscal years beginning after December 15, 2019 for all other companies.
Why is this important now?
Leasing, as a financing vehicle, is pervasive amongst companies of all sizes (leasing of real estate, vehicles, copiers and equipment). Given the substantial impact this new standard will have on the balance sheet, companies need to begin assessing the impact of this now. Consideration should be made to the implications of the new lease standards to key performance metrics, debt covenants, taxes and internal operations. The key performance metrics that are expected to be affected by these changes are the leverage ratio (debt/equity), current ratio (current assets/current liabilities), and Debt to Earnings before income taxes, depreciation, and amortization (“EBITDA”), as the new standards are adding liabilities to the books. Since lessees are adding the ROU assets to the balance sheet, it could also impact book to tax differences, state apportionment calculations, and personal property tax. From an operations perspective, companies will need to consider the impact of lease vs buy decisions, as they no longer have the benefit of off-balance sheet financing option that operating leases currently provides, such as no changes to the liquidity of the company and no changes to debt/liabilities.
What Companies should be doing to prepare
The most important thing companies need to do is start a dialog with accountants, creditors, and investors on how these changes will impact financial reporting. The next step is gathering all lease contracts and testing them to determine if they meet the criteria of a lease, and which category of leases they fall under. Management will need to analyze lease contracts for remaining terms, renewal options, future payments and interest rates, if applicable. At this stage, management will need to prepare estimated journal entries to move operating leases onto the balance sheet and analyze the impact of the adjustment on key metrics and debt covenants. In transitioning to the new accounting standard, entities are required to recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach. Using this information, management will need to make decisions on whether a company should buy vs lease assets, execute short term vs long term leases, or whether it is possible to include substitution clauses in lease contracts.
Join us on Wednesday, January 10, 2018 at 11:00am for a live webinar on the changes to lease accounting, designed to educate creditors, investors, and owners, while helping management navigate through the key changes with lease accounting.
ABOUT THE AUTHOR
Anthony Harrypersad, CPA is a supervisor in Citrin Cooperman’s White Plains and Norwalk office. He can be reached at 203.847.4068 or at firstname.lastname@example.org. Citrin Cooperman is a full-service accounting and consulting firm with 10 locations throughout the Mid-Atlantic region. Visit us at citrincooperman.com.