In 2016, the Financial Accounting Standards Board issued an Accounting Standards Update (ASC 842) that changed the way financial reporting will be done for leasing transactions. This change will affect all companies and organizations that lease assets such as real estate, airplanes and vehicles, and manufacturing equipment.
The reporting requirement responds to requests from investors and other financial statement users for a more faithful representation of an organizationâ€™s leasing activities, and ends off-balance-sheet accounting for leases. It takes effect for public companies for fiscal years beginning after December 15, 2018, and for private companies for fiscal years beginning after December 15, 2019.
ASC 842 will require organizations that lease assets â€“ referred to as â€œlesseesâ€ â€“ to recognize on the balance sheet the assets and liabilities created by the leases, for lease terms of more than 12 months. Current Generally Accepted Accounting Principles (GAAP) require only capital leases to be recognized on the balance sheet, but ASC 842 will also require operating leases to be recorded.
- Capital leases can be used to provide financing, where the lessor buys the asset and then rents it to the lessee for an agreed period. The lessee has an obligation to pay off the cost of the asset over the period of the lease. At the end of the lease period and depending on the details of the lease agreement, the lessor may have the option of extending the lease into an additional period, selling the asset to a third party, or returning it to the lessor to sell.
- In contrast to a capital lease, an operating lease does not transfer ownership to the lessee. Operating leases include everything a business rents to run its business, such as office space, equipment, warehouses, factories, planes and cars. Typically, operating leases are used for these types of assets, as they will have significant economic life left (unlike financing leases) at the end of the lease.
Under this new standard, the balance sheet for an operating lease will include a right-of-use (ROU) asset and a corresponding liability at the present value of lease payments to be made, discounted at either the rate implicit in the lease, if determinable, or the lesseeâ€™s incremental borrowing rate. The ROU asset will be recorded as the initial lease liability, plus any payments made at or before the commencement date, minus any lease incentive received, plus any other indirect costs.
Example Balance Sheet: Assets
|Property and Equipment, Net||$1,000,000||$1,000,000||–|
|Right to Use Asset – Operating||–||$500,000||$500,000|
Example Balance Sheet: Liabilities and Equity
|Current Maturities of Long-Term Debt||$50,000||$50,000||–|
|Current Portion of Operating Lease Liability||–||$159,648||$159,648|
|Long-Term Debt, Less Current Maturities||$700,000||$700,000||–|
|Operating Lease Liability, Less Current Portion||–||$340,352||$340,352|
|Total Liabilities and Equity|
The lease expense to be recognized depends on the lease type. Financing (capital) leases have two components to the related expense (amortization of the right-of-use asset, and interest), while operating leases have one component (lease expense). For financing leases, the lease expense will consist of straight-line amortization of the right-of-use asset over the life of the lease. The second component is the interest expense calculated on the lease liability at the interest rate used to discount this liability at initial measurement. Adjustments are made to the right-of-use asset for the calculated amortization, and the lease liability is first increased by interest expense calculated, then decreased by lease payments made.
WHATâ€™S THE BIG DEAL ABOUT THE NEW STANDARD?
With this accounting change, companies will be adding millions of dollars to the liabilities on their balance sheets. Companies with large amounts of operating leases include restaurants and retailers that lease properties, and construction companies, shipping companies and airlines that lease equipment, trucks, ships and airplanes.
The new standard will have a significant impact on the key metrics the companies report to their investors and banking institutions, as examples below show:
- Debt to equity ratio increases (debt added with no change to equity), lowering a companyâ€™s leverage
- Debt service coverage â€“ debt is added without a change to EBITDA (earnings before interest, taxes, depreciation, and amortization)
- Ratio of current assets/current liabilities decreases
- Working capital (current assets minus current liabilities) decreases
- Return on assets (net income divided by assets) decreases
WHO NEEDS TO PREPARE?
These changes may require investors and banks to reconsider the way they measure the financial criteria they use in making investment or funding decisions. A companyâ€™s leverage is determined by its debt to equity ratio, and is used by investors and lenders to evaluate the financial health of an organization. Â Specific financial ratios and performance metrics are also required by covenants, and the impact of ASC 842 will need to be taken into consideration.
Companies will need to determine first what leases they are already committed to, and assess whether they can negotiate their current and future lease terms. Generally, there will be an advantage of capital leases over operating leases due to the benefit of interest and depreciation add-back for the calculation of EBITDA. Every effort should be made to discuss the ratio and covenant impacts with users of their financial statements before changes take place.
In addition to changing the way that leases are reported, the new regulation will create a challenge for companies that have a significant number of lease agreements, as they must find a way to manage all that lease data. Some entities will need to invest in additional accounting automation, both to aid in reporting on the new requirements and to collect information for making future business decisions.
Questions about how the new standard will affect your reporting requirements or business strategy? Contact Dean Willingham, (505) 998-3218, or Michael Jacobson, (602) 731-3611 in our Commercial Department to discuss.