6 Strategies to Help Businesses Prepare for New Lease Accounting Rules by Whitney K. Schiffer, CPA
Posted on May 03, 2017 by Whitney Schiffer
Time is ticking away for businesses with operating leases to comply with new lease accounting standards that were issued a little more than a year ago by the Financial Accounting Standards Board (FASB). While the deadlines for public and private companies to implement the new rules is at least a year away, significant time and efforts will be required for most businesses to come into full compliance.
At the core of the new lease accounting standard is the way in which businesses account for and record on their balance sheets all assets and liabilities related to operating leases with terms greater than 12 months. Specifically, lessees will be required to disclose details concerning operating-lease transactions, including information about variable lease payments and options to renew and terminate leases. In addition, lessees will be permitted to make accounting-policy elections to exclude recognition of assets and liabilities relating to leases with terms of 12 months or less.
Under the current lease rules, businesses do not need to include operating leases on their balance sheets. Rather, they must reference these obligations only as footnotes on financial statements. As a result, businesses’ financial statements often exclude the true value of the entities financial performance, including their assets, credit risk and operating efficiency. Under the new rules, a business’ financial statements will materially reflect all lease transactions and will significantly change the way a business reports to stakeholders its performance, including its cash flow, net income and earnings before interest, tax, depreciation and amortization (EBITDA). Businesses will record a right-of-use asset and the corresponding lease liability on their balance sheets, measured at the present value of the lease payments. Additionally, they will record amortization of the right-of-use asset on their income statements, generally on a straight-line basis over the lease term.
Adapting to the new lease standard will be a time-intensive and perhaps arduous process that will require businesses to track down information about existing leases, project the potential impact they will have on financial reporting in the future, and establish new policies, procedures and systems to monitor lease transactions going forward. Complicating compliance to these new rules is a sea of additional new accounting standards that businesses must implement in the next few years, including, but not limited to, those related to recognizing revenue from contracts with customers, testing for goodwill impairment, measuring credit losses, and classifying cash receipts and cash payments. To ease this heavy burden, businesses must prioritize their efforts and consider the following tips specifically tailored to begin transitioning to the new lease accounting standard.
Six Ways to Prepare for Lease Accounting Rule
- Assemble a Team to Develop a Plan. Rather than diving into the new lease standards head first, businesses should take time to understand what is involved and how the new reporting rules will affect them. One of the best ways to do this is to establish a project management team that includes external and internal accounting and legal professionals, as well as key corporate managers, including those from IT, real estate, transportation and other business units. The ultimate goals of this team approach would be to develop a project transition plan, budget and timeline for implementation, tracking progress and taking steps to address any and all stumbling blocks that may occur along the way.
- Assess the Current Lease Environment and its Impact on Future Lease Reporting. Substantial time and effort may be required for businesses to identify all of their existing leases and the detailed terms and conditions and rights and responsibilities of those agreements. For example, the new standard for lease reporting will require businesses to recognize assets and liabilities for all leases with terms of 12 months or longer; shorter-term leases may avoid reporting requirements if the lessee does not expect to buy the asset(s) in the future. In addition, businesses will have the potentially complicated task of differentiating between reportable operating leases and service contracts, which they are not compelled to recognize on financial statements. In many situations, a business may uncover that an existing contract for real estate, equipment or other property meets the new definition of a lease and must be reflected in its financial reporting under the new guidance or it may recognize that the existing systems it uses to track leases will not suffice in the future. With these discoveries, a business may decide to renegotiate existing leases or forgo leasing altogether in favor of buying assets in the future, or it may decide to invest in a new system for tracking and monitoring leases in the future.
- Assess How the New Lease Standard Will Affect How the Business Communicates its Financial Performance. Because the new standard will represent the first time that many businesses will recognize operating leases on their balance sheets, the amount of lease assets and liabilities, cash flow and balance sheet ratios they report may be different than in prior years. This may present an equally significant difference in how businesses communicate their financial positions and operating efficiencies to investors, lenders and other stakeholders. For example, businesses with large portfolios of leases for office equipment, machinery, airplanes or portfolios of real estate may subsequently report increased amounts of debt owed on their lease obligations. Businesses should consider developing a plan that details how they will communicate these changes to lenders and other stakeholders in advance of the implementation deadline in order to avoid surprises and any adverse reactions.
- Invest in New Systems, Technology and Training to Record and Report Lease Arrangements. Due to the expanded disclosure requirements of the FASB’s new leasing standard, businesses will need more robust systems for capturing and reporting the details of their current and future lease contracts. This is especially true for business that have large portfolios of lease assets, for which software and other technology platforms may be the most efficient option for automating these processes in the future. For some businesses, this may be accomplished by simply working with vendors to update existing software; for others, it may require significant investment in new technology and training.
- Update Policies, Procedures and Internal Controls. Under the new lease reporting standard, businesses will need to differentiate between capital or finance leases and operating leases and report the expenses, cash flow and impact of both types of leases on companies’ assets, liabilities and shareholder equity. This could be a daunting task for businesses with large portfolios of lease assets. Not only will they need to develop new policies for classifying leases, they would also need to establish internal controls for monitoring, updating and analyzing lease data in a timely manner.
- Prepare for Comparative Reporting. The new lease accounting standards require a modified retrospective transition, for which businesses will need to apply the new guidance at the beginning of the comparative year. During the first year of compliance, businesses must provide comparative reporting on financial statements to reflect those operating leases that they previously did not account for on their balance sheets. With this retrospective reporting requirement, businesses will likely present on their financial statements significantly different assets, liabilities, income, cash flow and creditworthiness than in prior years.
Preparing for the new lease accounting rules is a monumental task that will require businesses of all sizes and in all industries to expend significant amounts of time, resources and dollars in advance of the December 15, 2018, deadline for public companies, and December 15, 2019, for privately held entities. By engaging experienced and knowledgeable auditors and accountants in the process, businesses may ease their compliance burdens and come away with new opportunities for improving their internal controls and long-term financial performance.
About the Author: Whitney K. Schiffer, CPA, is a director in the Audit and Attest Services practice of Berkowitz Pollack Brant, where she works with hospitals, health care providers, HMOs and third-party administrators, as well as real estate businesses. She can be reached at the firm’s Miami office at (305) 379-7000 or via email at email@example.com.