Lease Accounting Standard Is No Longer Delayed for Private Companies and Non-profit Organizations
After many years of being delayed, the Financial and Accounting Standards Board (FASB) met on November 15, 2021, and unanimously decided to no longer delay the lease accounting standard for private companies and nonprofit organizations. On February 25, 2016, the 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, and will be effective for fiscal years beginning after December 15, 2021.
Under the prior accounting we’ve followed, lessees and lessors are required to classify their leases as either capital or operating, which are accounted 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 generally accepted accounting principles (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 their 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.
For any company or organization, you need to start NOW! 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 classified as a 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 the 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.
For more information on updated accounting rules for leases and how Dannible & McKee can help you comply, contact us today.
Contributing Author: Sean T. Daughton, CPA, CFE, is an audit partner with over 25 years of experience providing audit and advisory services to a variety of clients, including automotive dealers, manufacturers and retail corporations. For more information on this topic, you may contact Sean at firstname.lastname@example.org or (315) 472-9127.