Preparing Your Business for Lease Accounting Changes
Updated accounting rules for long-term leases took effect in 2019 for public companies. Now, after several deferrals by the Financial Accounting Standards Board (FASB), private companies and private not-for-profit entities must follow suit. The new standard will apply to annual reporting periods beginning after December 15, 2021, and to interim periods within fiscal years beginning after December 15, 2022.
Unlike current generally accepted accounting principles (GAAP), which require only capital-type leases to be recognized on the balance sheet, the new guidance directs that a lessee is required to recognize right-of-use assets and liabilities associated with all long-term rentals on the balance sheet for leases with terms of 12 months or longer. The magnitude of recognized right-of-use assets and liabilities will be determined as a product of the lease term, required payments and the applicable discount rate used to calculate the present value of those obligations. While entities may be tempted to automatically exclude leases that are month-to-month or have a term of 12 months or less, the guidance specifies that adopters must utilize an “expected outcome” approach and must consider other economic factors when determining the applicable lease term.
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 the leases. In the notes to the financial statements, companies will need to disclose 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.
Implementing the new lease standard could take more time and money than most organizations realize. There are several specific issues that you’re going to need to carefully navigate to ensure a cost-effective and successful transition to the new standards. To help create a path to success, thoughtfully prepare in these areas:
- Compile a complete population of your leases, along with applicable lease terms and required payments. Gathering all documentation that has leases can be difficult and time-consuming, but it will help you have a solid idea of what exactly you’ll need to deal with. Don’t forget to look for related party leases, even if they’re unwritten.
- Consider utilizing specialized lease software. There are several software titles available to handle the accounting and reporting requirements of the new standard. While the software comes with a price tag, it will certainly help to minimize the time and effort needed to compile necessary information while providing a smooth transition to the new standard. You’ll need to look at the style and features of each to determine which one best matches your company’s needs.
- Identifying embedded leases. Some maintenance or service contracts may not be initially thought of as a lease; however, often there are identified assets within the contract that are controlled by your organization that are considered “embedded” leases. Under the new standard, you’ll need to capitalize these types of assets and account for them on your balance sheet, making them an important, but difficult to locate, type of lease.
- Decide on the discount rate you should use. There are some choices that will need to be made when deciding the appropriate rate to use when calculating the present value of a lease liability that will end up on your company’s balance sheet. Some leases include implicit rates that should be utilized; however, in the absence of an implicit rate, you will need to decide whether to use your company’s incremental borrowing rates or risk-free rates.
- Understand how the new standard will impact compliance with loan covenants. The right-of-use asset recognized under the new guidance will be classified as a long-term asset, while the lease liability will be separated between the current and long-term portion on the balance sheet. This could potentially have a substantial unfavorable impact on working capital, fixed charge ratios or similar liquidity and liability-sensitive ratios. 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 and compliance with loan covenants. Talk to your banker early to get out ahead of any non-compliance created by the implementation of the new standard.
- Work with your accountant. Communicate now with your auditor or accountant 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.
The implementation of the new leasing standard will likely impact a vast majority of companies in more ways than one. There will be significant time and effort needed to prepare. Your company’s balance sheet will look different, and this could have an impact on the reported financial health of your business. As we approach the end of the year, it is important to consider the points listed above and take the necessary action now to ensure you are ready to adopt the new standard for year-end financial reporting.
Contributing author: Benjamin A. Sumner, CPA, is an audit partner with over 12 years of experience providing auditing, accounting and advisory services to a wide variety of privately-held businesses.