What Firms Need to Know About the New FASB Standards for Leases
Do you have clients who issue GAAP-basis financials? How about clients who are nonprofit organizations? If your answer is yes to either question, then big changes to lease accounting are on the horizon.
On Feb. 25, 2016, the Financial Accounting Standards Board (FASB) released new standards for leases. These new standards are effective for years beginning after Dec. 15, 2018, for public companies, and for years beginning after Dec. 15, 2020, for all others. While the effective date is still a long way off, the extensive nature of the changes mean that many companies are already starting to work on the implementation.
What are the Changes?
Currently, only capital leases are reported on the balance sheet. Capital leases are a common financing method for equipment. At the end of the lease term, the lessee typically has the option to purchase the equipment for a “bargain purchase price” – commonly $1. The leased asset and the related liability both appear on the balance sheet.
Operating leases, which are typically for office or warehouse space, or for equipment or vehicles, are currently only disclosed in footnotes. As the SEC noted in a 2005 study, future payments on operating leases can be significant. This difference in reporting may lead companies to structure leases so that they qualify as operating leases even if, in substance, they are more like capital leases. Keeping the future lease obligations off the balance sheet can make companies appear healthier than they are.
Under the new standards, both types of leases will appear on the balance sheet. For operating leases, this means that an asset (the right to use the leased asset) and a liability (the present value of the expected payments under the lease) will be recorded on the balance sheet. Capital leases will continue to be accounted for in much the same way as they are currently. These changes will apply to all leases in effect at the time the standards become effective.
The standards hinge on the concept of “right of use” for tangible assets. Both operating leases and capital leases convey the right of the lessee to control the use of an identified asset (or assets) for a certain period of time. Under the new standards, any agreement that grants the right of use of tangible assets will fall under the new reporting standards. This may include agreements or contracts that aren’t currently considered leases, but grant the right to use specific equipment or other property.
On the income statement, capital leases will have two front-loaded expense items: an amortization expense for the asset and an interest expense on the lease obligation. Operating leases will have a straight-line lease expense over the term of the lease: a combination of amortization of the leased asset and interest expense for the lease obligation.
What’s Not Included
Short-term leases with terms under one year and leases for the right to use intangibles, such as trademarks, are excluded. Renewable short-term leases are also excluded, unless it is “reasonably certain” that the lease will be renewed. Service contracts are excluded to the extent that there is no right of use component to the contract. These changes will not impact businesses that use the tax basis of accounting.
What to do now
Small businesses and nonprofits that fall under the new lease standards should begin gathering all of their lease documents and other contracts. It may take some time to evaluate these agreements to determine how they will be accounted for under the new standards.
Businesses with informal agreements, including self-rentals, should formalize these agreements. Nonprofits that lease space at a discount from a donor will need to calculate the lease asset and obligation at the fair market value of the lease. The discount from fair market value will be recorded as a contribution from the donor.
Business owners should review any debt covenants that specify a debt-to-equity ratio. Because the new standards require the recognition of additional liabilities for operating leases, these changes may result in the violation of debt covenants as they are currently stated. Business owners may need to renegotiate loan agreements with their bankers, who may not be aware of the new standards.