Navigating the New Lease Accounting Guidance
With year-end reporting finished, many companies are turning their attention to a Financial Accounting Standards Board (FASB) Accounting Standards Update that changes how leases are reported in financial statements.
“While that may seem a simple accounting change, the transition will require significant work,” said Paul Dunn, business advisory partner for Montgomery Coscia Greilich LLP.
Dunn observed that the update “requires a company to go back and re-examine all of their lease agreements. Companies have to evaluate the impact on financial statements. It changes policies and processes.”
Currently, leases are categorized as either: 1) capital leases, which are treated like loans where an asset is considered to be owned by the lessee; or 2) operating leases, which are treated like rentals. Under current guidelines capital leases are shown as assets and liabilities on an organization’s balance sheet while operating leases are treated as expenses and typically reported in footnotes.
Under the new FASB guidance, leases will be categorized as finance leases (the new name for capital leases) or operating leases, with both reported on the balance sheet. For operating leases, companies will declare a lease liability and a right-of-use asset on the balance sheet.
How do the changes impact you?
“Companies must still classify leases based on how much of an asset’s value is consumed by the lessee during the lease term so it is properly represented on the Profit and Loss statement,” states MCG audit partner, Zak Everson. “Assets such as vehicles and equipment, which lose value relative quickly, are classified as Type A leases while assets such as buildings and land, which lose value more slowly or even increase in value, are classified as Type B leases.”
Public entities are required to adopt the new standard for fiscal years that begin after December 15, 2018, including interim periods within that fiscal year. So for public entities whose fiscal year follows the calendar year, the standard would be effective January 1, 2019. Nonpublic entities have an extra year (until January 1, 2020) to adopt the standard. However, companies have the option of implementing the new standard for any reporting period after it was issued on February 25, 2016.
“Leases lasting less than a year and a few [other] categories of leases are excluded from the new standard,” said MCG consulting manager, Jeff Weinberg. Companies can also opt for a Practical Expedients option, which allows them to avoid reclassifying existing leases.
“You still have to make a determination and record operating leases as an asset and a liability on the balance sheet for all the affected periods, but you don’t have to go back and reassess how you originally classified the lease,” Weinberg noted.
A primary benefit of the new standard is investment transparency. “This will help the investing public understand the value of a company by having all of its assets, including its lease assets, on the balance sheet,” Dunn stated.
The change will require an evaluation of lease agreements and a determination of the value of the right of use. The first step to the re-evaluation process is a practical one: finding all the company’s leases and lease amendments. For a company with many leases, that can be a daunting task. In addition, a long-term lease may have multiple amendments which also must be evaluated.
“The change in reporting may impact debt covenants, restrictions in borrowing agreements designed to limit risk to the lender,” said a principal with MCG.
According to Weinberg, “The new reporting standards may also make companies re-evaluate lease vs. buy decisions and impact strategic planning.”
“It’s going to have a significant impact on the way companies with a large number of leases do business.”
Help Navigating the Transition
MCG recommends that companies begin planning for the implementation early. Not only is there significant work involved, but companies also need to think about the impact on comparable financial statements, which will require up-front planning.
Once an implementation plan is in place, companies and their relevant stakeholders will feel more at ease knowing that there is a roadmap for getting it done.
MCG has developed a four-phase roadmap to help clients navigate the transition process:
1) Establish resources and create an implementation task force;
2) Identify all leases and select transition method;
3) Analyze effect on all areas of business; and
“This is a fairly easy exercise for professionals well versed in the guidance,” Everson stated. “Most middle-market companies will have limited bandwidth to transition, especially if they have a high number of operating leases. Updating books and records for compliance with differing accounting policies will take time.”
MCG offers a range of services to help clients make the transition to the new standard.
The MCG team noted, “We can help make sure that leases are categorized appropriately. We can also help analyze the impact on debt covenant compliance, the effect on a company’s operating system, and development of necessary controls, policies and procedures.”
For companies with only a few leases, MCG can advise them on the appropriate valuation of lease liabilities and assets as well as help ensure that proper disclosures are in place. For companies with many leases, MCG can assist clients in finding a software system to manage reporting obligations.
Weinberg notes that although “the transition process may be complex and time consuming, the process offers a chance to reconsider some decisions.”
“This will be an opportunity to look at how leases are handled and, perhaps, to think about strategic changes, especially as new leases are negotiated,” he said. “I think many companies will find the process worthwhile in the end.”