Businesses Must Prepare Now for New Lease Accounting Standards by Hector E. Aguililla, CPA
Posted on June 28, 2016 by Hector Aguililla
Businesses that lease assets ranging from office and manufacturing equipment to airplanes and portfolios of real estate will need to contend with a new standard for reporting those leases on their balance sheets in the future.
On February 26, the Financial Accounting Standards Board (FASB) released a new lease accounting standard that it expects will provide lenders, investors and other users of financial statements with a clearer, more accurate picture of a company’s financial health. For lessees, the new rules contained in ASU No. 2016-02 Leases (Topic 842) could add significant costs and complexities to their operations and liabilities to their balance sheets. As a result, businesses should begin the process of planning now, in advance of the required implementation date of December 15, 2018, for public companies and December 15, 2019, for all other entities.
Under current accounting principles, businesses must determine whether to classify leases as capital leases or operating leases, based upon the risks and rewards of ownership transferred to them from the arrangement, and account for each one differently. Capital leases are recognized on balance sheets as both assets and liabilities, for which businesses may claim depreciation and annually deduct interest expense of lease payments.
Conversely, with an operating lease, businesses treat lease expenses as operating expenses on income statements and exclude lease assets and liabilities entirely from their balance sheets. The only mention of such operating lease obligations are included as footnotes on a business’s financial statements. By keeping these lease contracts off of their balance sheets, businesses essentially avoided reporting the true economics of their lease assets and their obligations to pay for those assets, thereby presenting investors and lenders with a skewed representation of their businesses’ asset and credit risk. As a result, the FASB and the International Accounting Standards Board (IASB) began to look at changing the current model as early as 2006.
Enter the New Lease Accounting Standard
Under the new lease accounting standards, businesses will be required to begin reporting on their balance sheets the assets and liabilities related to all of their leases with terms of more than 12 months. Businesses will also be required to disclose qualitative and quantitative information about lease transactions, such as information about variable lease payments and options to renew and terminate leases. For public companies, the new standard will be effective for fiscal years beginning after December 15, 2018; all other entities will have until December 15, 2019, to adopt the new standards for calendar years or after December 15, 2020, for all interim periods. Early adoption will be permitted for all organizations.
The new standard will mark the first time many businesses will recognize operating leases on their balance sheets. As a result, the amount of lease assets and liabilities they report may be different than in prior years, which may present an equally significant difference in their financial positions. For example, businesses with large portfolios of lease agreements, such as retailers, banks, construction and shipping companies, may report increased amounts of debt owed on lease obligations. This may essentially change the way investors and lenders view a business’s contractual obligations, its financial picture and its operating efficiency.
Preparing for the New Leasing Standard
While the new leasing standards do not go into effect for some time, it behooves businesses to begin preparing for the changes now in order to minimize the impact on their operations and financial statements in the future.
Some businesses will experience significant changes to their balance sheets and profits. In addition, because businesses will need to implement the new rules retroactively, they may need to spend time tracking down their rights and obligations relating to assets previously underrepresented on their balance sheets and put into place new systems for monitoring and tracking these arrangements in the future. This may require businesses to adopt new technology and incur additional costs, for which budget estimates should be calculated sooner, rather than later.
To help make the transition to the new standard easier, the FASB will require reporting organizations to take a modified, retrospective approach, rather than a full-retrospective transition approach. Furthermore, the FASB includes a number of practical and optional expedients reporting organizations may take to make the transition as efficient as possible.
The new leasing standards may also affect how businesses asses their decisions to lease versus buy property or needed equipment. For example, it may be more economically advantageous for one business to buy rather than lease equipment, or a business may seek to modify the terms of existing leases in order to reduce the impact on their future financial statements.
Early preparation to minimize the impact of the new standards will require businesses to commence the following activities:
- Take inventory of all existing lease arrangements and debt covenants
- Identify how the business will track and monitor all current and future lease arrangements to comply with the new standard
- Understand how the new standards will affect the business’s balance sheet, credit rating and access to debt
- Identify opportunities to save costs and minimize impact on the business’s operations and financial position, including negotiating lease terms
- Seek the counsel of experienced accountants and auditors, who can help to assess the impact of the new standards and develop a plan to make the transition as simple and economical as possible.
About the Author: Hector E. Aguililla, CPA, is an associate director with Berkowitz Pollack Brant’s Audit and Attest Services practice, where he provides audit and accounting services, litigation support and consulting services to business clients. He can be reached in CPA firm’s Miami office at (305) 379-7000 or via email at email@example.com.