Five Things to Consider Under the New Lease Accounting Standards

Published on May 24, 2016

The Financial Accounting Standards Board (FASB) released the long-awaited lease accounting standard on Feb. 25. The first exposure draft on the topic was originally released in August 2010 and has undergone several revisions. 

Although there are several elements of the standard, the most significant is the requirement for lessees to include the future lease payments on the balance sheet as a liability and a related right-of-use asset. Leases with terms less than one year are excluded from recognition. 

The impact on the income statement is not expected to be as significant, but depending on the lease agreements, the impact to the balance sheet could be large. A review of fiscal 2014 public company filings found more than a trillion dollars of undiscounted lease obligations not already capitalized. 

The lease standard is expected to provide readers of financial statements with a clearer picture of a company’s lease obligations, but will require significant work to account for this change. The effective date of the standard is 2019 for public entities and 2020 for non-public entities. 

There are several things that should be considered to be ready for implementation. 

Plan early to facilitate adoption

Besides the accounting changes, companies are required to disclose more qualitative and quantitative information about their leases. The plan should be tailored for each business group, include a schedule for completing key activities and the recording of important milestones. 

Review existing systems

CFOs should think about whether their companies have appropriate systems and internal controls to record the lease data needed to comply with the new rules, including the expanded disclosure requirements. Business units likely will need to interact and communicate with the finance function in new ways. 

Consider the impact on loan covenants

Many credit agreements include financial covenants which require companies to maintain certain levels of liquidity and earnings. Understanding the impact on these calculations in current negotiations of debt terms could prevent the need and costs to renegotiate and amend the credit agreement in the future. Unlike current capital leases, the amortization of the right-of-use asset will be included in lease expense in the operating section of the income statement and will not increase EBITDA. The company’s debt to equity ratio, on the other hand, could be significantly impacted. If the definition of liabilities is not adjusted to exclude the lease liability, or the acceptable ratio is not adjusted, noncompliance could occur. 

Set aside time to evaluate leases

As part of the new lease standards, each contract will need to be evaluated to determine whether there are lease and non-lease components. Non-lease components could include a service agreement which should be allocated a portion of the consideration and are excluded from the lease liability calculation. Each contract will need to be reviewed to determine if the lease is an operating lease or a financing lease. The definitions of operating and financing leases are similar to operating and capital leases under current guidance. This contract evaluation is expected to be time intensive and will likely require significant changes to the current internal control systems of an entity. 

Consider educating investors and other financial statement readers

As the point of implementation draws near, it will also be important that the readers of financial statements are aware of the impact and are educated on the change to reduce frustration and confusion down the line. The increased assets and liabilities could likely make an entity appear to be substantially larger, but without an increase in equity, and could give the impression the company is less efficient in its use of assets.

(Source: AICPA - CPA Letter Daily - Houston Business Journal May 3, 2016)