Earlier this year, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2016-02, the FASB’s long-awaited overhaul of its lease accounting rules. The ASU makes extensive changes to the treatment of lease transactions, particularly for lessees.
What do the new rules require?
The most significant change involves operating leases. Under current Generally Accepted Accounting Principles (GAAP), leases are classified either as “capital” or “operating” leases. Although the rules for classifying leases are complex, in general a capital lease transfers ownership of leased assets to the lessee, while an operating lease simply transfers the right to use the leased assets during the lease term. To keep leases “off the books,” most companies prefer to structure leases as operating leases, which need not be reported on their balance sheets (though they require certain footnote disclosures).
To make it easier for financial statement users to compare companies that own their productive assets with those that lease them, the ASU requires lessees to report all leases on their balance sheets, regardless of how they’re classified. There’s an exception, however, for short-term leases — those with terms of 12 months or less. For leases subject to the new rules, you’ll recognize a “right-to-use” asset and a corresponding lease liability (both based on the present value of minimum payments under the lease) on your balance sheet.
The new standard retains the distinction between operating leases and capital leases (referred to as “finance” leases) for purposes of reporting lease expenses on your income statement. For operating leases, you’ll generally recognize rental expense on a straight-line basis. For finance leases, however, you’ll amortize the right-to-use asset separately from interest on the lease liability. This will result in “front-loaded” expense recognition, similar to a loan.
How much time do you have?
The new rules will apply to fiscal years starting after December 15, 2019 (a year earlier for public companies). That may seem like a long way off, but consider making preparations soon. Evaluate the new leasing standard’s potential impact on your financial statements and talk to your sureties and lenders about how it might affect your bonding capacity or compliance with loan covenants.
Also, keep in mind that the ASU calls for a “modified retrospective” transition. This means you’ll have to apply the new rules as of the beginning of the earliest comparative period presented on your adoption-year financial statements. In other words, if you include comparative financial information in your financial statements, you’ll need to have appropriate reporting systems, processes and internal controls in place well before the effective date to ensure that you collect the information you need to implement the new rules.
To ease the burden of this transition, the ASU allows you to elect certain “practical expedients.” Generally, these elections permit you to continue using most aspects of current GAAP to account for existing leases (unless they’re modified), although you’ll still have to report an asset and a liability on your balance sheet.
How will this affect surety bonds and loans?
If you lease real estate, equipment and other assets, implementing the new standard will significantly increase the assets and liabilities recorded on your balance sheet. This, in turn, may affect your bonding and lending relationships.
Although your net worth won’t change, additional liabilities may make your balance sheet appear weaker, which may increase your borrowing costs or reduce your bonding capacity.
Another potential concern is that the new standard will negatively impact loan covenants that place limits on the total amount of debt you may incur or require you to maintain certain debt-to-equity levels. To avoid causing companies to violate loan covenants, the ASU specifies that lease liabilities should be treated as “other liability,” not “debt.” But the actual impact on your company will depend on your loan agreements’ language and the specific financial ratios used.
To prepare for the new leasing standard, review your current and contemplated leasing arrangements, evaluate the standard’s potential impact on your financial statements and ensure your financial reporting systems are equipped to collect the information you’ll need to comply. In addition, talk to your lenders and sureties to discuss the impact of the new standard, if any, on your ability to obtain financing and bonding.
Watch out for combined contracts
It’s not unusual for contracts to contain both lease and nonlease components. For example, an equipment lease might also include an agreement to provide maintenance services. Under the Financial Accounting Standards Board’s Accounting Standards Update (ASU) No. 2016-02, it will become more important to separate a contract’s lease and nonlease components and to account for nonlease components separately under other standards.
To avoid the burden of allocating the contract price between lease and nonlease components, you may elect to account for them together as a single lease component. But in light of the on-balance-sheet treatment of leases, there may be a significant advantage to putting processes into place to identify and value the lease and nonlease components of your contracts.