By Ryan C. Peck, CPA
Senior Accountant & Auditor
Since the process of enhancing the lease accounting standard began in 2006, and given several delays of the implementation dates, it sometimes seemed as if the new standard would never become a reality. But the time has come.
Standard Summary
In 2016, the Financial Accounting Standards Board (FASB) approved Accounting Standards Update (ASU) 2016-02, “Leases,” further modified by ASU 2018-11, which requires companies to shift their lease obligations to the balance sheet. This new standard is designed to more accurately portray a company’s financial position. After a few years of deferrals (most recently to provide relief to companies during the Covid-19 pandemic), the time has come for private companies and not-for-profit organizations to adopt the standard. Private companies and not-for-profit organizations are required to implement these new changes for fiscal years beginning after December 15, 2021.
What should my organization know?
Under the new lease standard, most leases will be recorded as liabilities on the balance sheet along with a “right of use” (ROU) asset. Previously, only capital leases (now called “financing leases”) were recorded as liabilities with offsetting assets that were depreciated. Now, operating leases are required to be put on the balance sheet as well. However, short-term leases with original terms of 12 months or less will continue to be exempt from this new standard, if they do not include a purchase option that the lessee is reasonably certain to exercise.
The initial lease liability and ROU are recorded on the balance sheet at the present value of the expected future lease payments. As payments on the lease are made, the ROU asset and lease liability will be amortized, similar to a building or mortgage loan, respectively. Lease expense will be recorded on the income statement, which consists of interest and amortization. Interest expense will be greater in the early stages of the lease, similar to a mortgage or car loan, based on the lease liability balance. Amortization expense will be recognized on a straight-line basis over the life of the lease.
When negotiating and reviewing lease terms, a company must keep in mind that the longer their lease term, the greater the liability on the balance sheet. In certain circumstances, the lease term can include a renewal option period, which increases a company’s liabilities and ultimately alters their debt-to-equity, capital and leverage ratios. Organizations must be aware of this change as it will affect their ability to meet certain covenants required by their lenders.
How can I prepare?
Leading up to the effective date of the new lease standard, organizations should be proactive and prepare for these changes. To reduce balance sheet liabilities, organizations can try to modify lease agreements with the lessors. However, for most property leases, modifying leases with related parties to be “short-term” may not avoid recording the liability, especially if the mortgage loan payments depend on the lessee’s ability to make lease payments or if the mortgage loan is guaranteed by the lessee.
If lease terms cannot be adjusted, companies should discuss the new standard and its impact on their financial position with their lenders. Typically, loan covenant calculations exclude intangible assets such as ROU assets. Similarly, financial ratio covenant calculations can be renegotiated to exclude lease liabilities. Having these important conversations months prior to the standard becoming effective can help organizations better forecast for the future.
We will reach out to our clients over the next few months to discuss preparation for the new lease accounting standard. In the meantime, if you have questions, please contact us.
