New Accounting Rules for Leases
On February 25, 2016, the Financial Accounting Standards Board (FASB) issued an Accounting Standards Update (ASU) intended to improve financial reporting of leasing transactions. This ASU affects all companies that lease assets such as real estate, cars and trucks. For private companies, the new standard on leases will take effect for fiscal years beginning after December 15, 2019 (calendar year 2020). Early application will be permitted for all companies.
Under the current accounting model, lessees and lessors are required to classify their leases as either capital or operating leases, and to account for those leases differently. Those models have been criticized for failing to meet the needs of users of financial statements because they do not provide a faithful representation of leasing transactions, particularly obligations of lessees.
Under the new guidance, a lessee will be required to recognize assets and liabilities for leases with lease terms of greater than 12 months. Consistent with current Generally Accepted Accounting Principles (GAAP), the recognition, measurement and presentation of expenses and cash flows arising from a lease by a lessee primarily will depend on its classification as a finance or operating lease. However, 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 will require disclosures to help financial statement users better understand the amount, timing and uncertainty of cash flows arising from leases. These disclosures include qualitative and quantitative requirements, providing additional information about the amounts recorded in the financial statements. For example, companies will need to disclose in the notes to the financial statements information about the nature of its leases, the significant judgments made in applying the requirements in this Accounting Standards Update, and various other desegregation of amounts and features related to leasing activity.
Lessor accounting will remain largely unchanged from current GAAP. However, the new standard contains some targeted improvements that are intended to align lessor and lessee accounting with the updated revenue recognition guidance issued in 2014. At first glance, one may expect that the changes would not have much of an impact on the financial statements. However, for companies with significant operating leases, the changes may have a significant impact on working capital. As many loan covenants contain minimum working capital requirements, the new requirement to add the current and long-term liability for operating lease payments to the balance sheet could cause a company to fall out of compliance with their loan covenants. The right-of-use asset recognized would be classified as a non-current asset, while the current portion of the lease liability would be current liability.
Debt-to-equity and debt service ratios would also be affected by the proposed lease accounting changes because a company‘s debt would increase by the present value of future lease payments. A debt-to-equity ratio that was in compliance under current guidance could turn unfavorable. Debt service costs would also increase due to the component of the lease payments that would be included in interest expense.
Although the economic fundamentals of the company have not changed in any way, the company could now be out of compliance with loan covenants as a result of the adopting of this new standard. 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.
Additionally, implementation of this standard may require significant personnel costs to evaluate existing leases. The company will need to include virtually all leases on their balance sheet. This evaluation could take considerable amount of time and effort depending on the complexity and volume of current leases.
For more information on updated accounting rules for leases and how Dannible & McKee can help you comply, contact us at 315-472-9127.