Implementation of New Lease Accounting Standard Deferred One Additional Year for Private Companies
On February 25, 2016, the Financial Accounting Standards Board (FASB) issued an Accounting Standards Update (ASU) intended to improve the financial reporting of leasing transactions. This ASU affects all companies that lease assets such as real estate, construction equipment, cars and trucks.
Publicly traded companies were required to begin implementation for years beginning after December 15, 2018 (calendar year 2019). For private companies, this new standard was originally required to take effect one year later, in fiscal years beginning after December 15, 2019 (calendar year 2020). However, on July 17, 2019 the FASB voted in approval of a proposal to extend the implementation requirement by one year. This vote was affirmed in its October 16, 2019 meeting, and the final accounting standard update to extend the effective date for private companies will soon be issued. While the extension has provided private companies with additional time to implement this change, there will be several hurdles to overcome in order to properly implement the new standard that companies should still be preparing for now.
Under the accounting we’ve followed for years, lessees and lessors are required to classify their leases as either capital or operating, which we account for differently. Leases currently classified as operating leases are not reflected in a company’s balance sheet, rather lease payments are expensed as incurred. This model has been criticized for failing to meet the needs of users of financial statements because it does not provide a faithful representation of leasing transactions, particularly the financial obligations of lessees.
The new guidance directs that a lessee will now be required to recognize assets and liabilities on the balance sheet for all leases with lease terms of greater than 12 months. Unlike current GAAP, which requires only capital-type leases to be recognized on the balance sheet, the new standard will require both types of leases to be recognized on the balance sheet.
The new standard also directs changes to required disclosures to help financial statement users better understand the amount, timing, and uncertainty of cash flows arising from your leases. Companies will need to disclose in the notes to the financial statements more information about the nature of its leases, the significant judgments made in applying the requirements of the new standard, and various other amounts and features related to particular leasing activities. This area is probably the most significant change that would require the assistance of a CPA to ensure you have all bases covered.
Lessor accounting remains largely unchanged from current GAAP. However, the new standard contains some targeted improvements that are intended to align lessor and lessee accounting with other previously issued revenue recognition guidance.
As discussed above, publicly traded companies have largely already been required to follow this new guidance. We have learned a few lessons on implementation from these publicly traded companies that should be taken very seriously by private companies when going through the evaluation and implementation process:
- Start early – Many public entities reported that implementing the new lease accounting was more challenging and required a larger cross-sectional effort than anticipated.
- Review agreements and lease inventory – Identification of the population of leases and review of all lease agreements was consistently noted as a challenging aspect of implementation across all companies. Starting early and forming a plan of action is very important.
- System selection – Consideration should be taken into whether or not to utilize new software to account for leasing activity under the new standard, or to utilize existing software. Testing of your current system is critical to identify its ability to handle the new reporting requirements.
- Accountant communication – Communicate early with your auditor or accountant in order to understand their process of auditing or reviewing the leasing activity and financial statement disclosures in order to aid you with developing internal accounting policies, procedures and internal controls around the new leasing standard.
It’s important that you take a test run in applying the new guidance to see how it impacts the presentation of your balance sheet. The right-of-use asset recognized under the new guidance would be classified as a non-current asset, while the current portion of the lease liability would be current liability. Implementation of the new standard may affect your business’s satisfaction of certain debt covenants which may be present in your bank borrowing agreements. For companies with significant operating leases, capitalizing these new liabilities may have a substantial impact on working capital, fixed charge ratios or debt to net worth and other, similar liability-sensitive ratios. In short, ratios that were in compliance under current guidance could turn unfavorable, merely as the result of implementation of required accounting guidance: what was once considered a healthy company might now appear to be a poor credit risk and the decreased ability to obtain funding could have a real, adverse effect on the financial health of the company.
Our experience so far has indicated that the banking community is quite aware of these changes coming down the road. Nevertheless, we counsel that you investigate sooner than later the impact of the new guidance on your financial statement presentation and financial statement covenant ratios. Remember, the company will now need to include virtually all leases on the balance sheet. This evaluation could take a considerable amount of time and effort depending on the complexity and volume of current leases.
Contributing author: Benjamin A. Sumner, CPA, is an audit partner with over nine years of experience providing auditing, accounting and consulting services to a wide variety of privately-held businesses. For more information on updated accounting rules for leases and how Dannible & McKee can help you comply, contact us today.