On February 25, 2016 the Financial Accounting Standards Board released Accounting Standards Update 842 dealing with lease accounting. The update intends “to increase transparency and comparability among organizations by recognizing lease assets and liabilities on the balance sheet and disclosing key information about leasing arrangements.”
ASU 842 will require leases to be recognized on the balance sheet, a significant shift from the previous accounting treatment. The change applies to all leases for equipment, real estate, and other leasable assets.
These changes impact most companies headquartered in the United States that follow General Accepted Accounting Principles (GAAP) standards. The effective date for implementing these changes is January 2019 to provide ample time to implement these new regulations but companies are welcome to adopt these new standards sooner, if they so choose.
Going forward, the term Capital lease will be retired. All leases will now either be categorized as “Finance” or “Operating.” Finance leases are effectively structures that transfer ownership at the end of the term for a nominal fee, provide an option to purchase that the lessee intends to exercise, or a lease term that is the length of the useful life of the asset. All other leases are classified as Operating Leases.
FASB continues to recognize two types of leases and the accounting treatment that should be applied to each. The broad considerations of the changes are:
• Any asset that is leased with a term longer than 12 months must be recognized on the balance sheet as a “Right to Use” asset regardless of whether it is a finance or operating lease.
• Finance leases will require that the lessee bifurcate the interest payment associated from the deprecation of the asset over the term of the lease and any options.
• Operating Leases can be shown as a straight line expense over the term of the lease by recording the value of the right to use asset along with the corresponding liability on a present value basis.
• Most accounting rules will not change for Lessors, although some terminology may be redefined to align with Lessee regulations.
When calculating lease asset and liability values all costs directly associated with the underlying asset will be included. For example, charges such real estate taxes will be considered as part of the value of the lease, but janitorial cleaning services would be excluded and considered a separate expense. The above notwithstanding, in a nod to expediency, lessees can choose not to separate these components if that policy is applied to the entire asset class.
Issues for the accounting department and the CFO to consider as part of the new standards:
• How accurate are the current lease records?
• Can the direct lease costs identified and quantified? These may need to be recognized differently than the lease obligation itself.
• Where is the company’s data being stored currently? Is the information easily accessible?
• Who is managing the database of information and maintaining the integrity of the data?
• What department will be responsible for managing lease costs and reporting going forward? Accounting? Procurement? A hybrid shared services department?
• Do we have the necessary data to explain the impact of these changes to investors?
While any lease liabilities will be included on the balance sheet, the corresponding assets will also be placed on the balance sheet. This won’t impact the overall net worth of a company. This may impact some companies capital structures as debt to equity ratios will be impacted when operating leases get added to the balance sheet. Highly leveraged companies that were already close to their ratio thresholds will have to discuss these impacts with their lenders.
I recommend huddling with your accountant and real estate adviser to understand exactly how these changes will impact your business and what steps are necessary to fully comply.