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Does your company lease office space, equipment, real estate or other assets? If so, and it follows U.S. Generally Accepted Accounting Principles, take note of new lease accounting guidance the Financial Accounting Standards Board (FASB) issued earlier this year. The guidance, Accounting Standards Update (ASU) No. 2016-02, Leases (Topic 842), takes effect in fiscal years starting after December 15, 2018, for most public companies, and for fiscal years beginning after December 15, 2019, for many other organizations. Companies can choose to apply the standards earlier, however.
According to the new guidelines, many public and private businesses will need to recognize all leases with terms of at least 12 months on their financial statements. Under the previous standards, companies were required to recognize only capital leases on the financial statements.
The FASB’s intention in issuing ASU 2016-02 is “to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements.” According to the FASB, users of financial statements need complete, understandable pictures of companies’ leasing activities — and past forms of lease accounting didn’t always provide this. (Although the update also addresses lessor accounting, the changes to it aren’t as dramatic.)
The update classifies leases as either “finance” or “operating” based on several attributes. Finance leases transfer ownership of the underlying asset to the lessee by the end of the lease term, which covers the major part of the remaining economic life of the asset. Leases that don’t meet the criteria established for finance leases are classified as operating leases.
The accounting for leases on the income and cash flow statements varies slightly, depending on whether they’re operating or finance leases. But, on the balance sheet, both types of leases will include a right-of-use asset and lease liability, initially calculated as the present value of the lease payments.
Lessees also need to provide quantitative and qualitative disclosures about their leases within their financial statements. These include:
- General descriptions of the leases,
- The basis, terms and conditions on which variable lease payments were determined, and
- Any restrictions or covenants the leases imposed, such as those that restrict the lessee’s ability to take on additional financial obligations.
The purpose of these disclosures is to provide more detailed information to users of your financial statements.
Time to begin
ASU 2016-02 will necessitate changes in many companies’ accounting processes, systems and training. In addition, the guidance may have an impact on companies’ financial statements and ratios, possibly affecting their ability to comply with debt covenants. Shifts in lease-vs.-buy decisions also may be required.
Thus, while the effective dates are several years away, it’s advisable to begin preparations now. To start, you’ll need to assemble an inventory of leases across your organization. Doing so may require identifying the lease portions of service agreements. You’ll also need to determine whether leases are financial or operating.
In addition, your company needs to assess whether its existing systems and controls are capable of efficiently providing sufficient lease-related information on an ongoing basis. If not, you’ll need to determine what changes are required and identify other contracts or agreements affected by the changes.
In particular, and as mentioned, ASU 2016-02 adversely affects compliance with loan agreements — specifically those that require you to maintain certain debt-to-equity ratios. You may want to modify these agreements before the new rules become effective. Going forward, you’ll want to conduct lease-vs.-buy analyses, keeping the new regulations in mind.
Obviously, the changes in lease accounting imposed by the new standard are complex, and this summary isn’t intended to cover all possible nuances. Click here to contact us to learn how these changes will impact your company.