Lease Changes Are Coming
October 24, 2017
Upcoming changes in accounting for leases will significantly impact financial reporting for almost all companies.
Current Lease Accounting
Under current lease accounting, only capital leases are recognized on the balance sheet. Capital leases require an asset and related lease liability equal to the present value of the minimum lease payments. The capital lease payment includes principal and interest. The principal payment reduces the lease liability and the interest portion is recorded as an expense on the income statement. Currently, operating leases are not reported on the balance sheet and the lease payments are simply treated as an operating expense on the income statement. Financial Accounting Standards Board’s Accounting Standards Update (ASU) 842 will dramatically change how companies account for leases.
Future Lease Accounting
The lease accounting updates with ASU 842 are intended to improve transparency in company financials. The new standard defines a lease as a contract, or part of a contract, that conveys the right to control the use of an identified piece of property, plant, or equipment (an identified asset) for a period of time in exchange for consideration. A company controls an identified asset when it has the right to direct its use and the right to obtain substantially all of the economic benefits from its use. After identifying a lease the company will need to classify which type of lease it is.
Under ASU 842, leases will be classified as a finance lease (capital lease) or operating lease. Essentially all leases, including operating leases greater than 12 months, will be recorded on the balance sheet with a Right of Use (ROU) asset and a related lease liability. Being a finance lease or operating lease has no impact when initially recording of the ROU asset and lease liability. However, how the expense is recognized over the life of the lease will depend on the lease classification. Operating lease costs will generally be expensed over the lease term on a straight light basis. Finance leases will record both amortization expense on the ROU asset and interest expense on the lease liability. The lease term should include renewal periods if the lessee has significant economic incentive to extend and is likely to do so.
Lease definition, lease classifications, lease terms, expense recognition, financial statement presentation, and disclosure requirements are just some of the changes to consider under the new accounting standard. Public companies are required to adopt ASU 842 for periods beginning after December 15, 2018. Non-public companies are required to adopt ASU 842 for fiscal years beginning after December 15, 2019 (calendar year 2020). Early adoption is permitted. Companies should begin collecting all current lease data, analyze the impact the change in accounting will have, and develop an implementation plan with processes to manage the accounting for leases going forward. In addition, companies should reach out to their bankers to discuss how the changes may impact financing agreements, specifically with financial covenants. Companies will have additional debt under the new lease accounting, which may affect certain financial ratios used for loan covenants. We encourage companies to start planning now.
If you’re interested in discussing the changes in lease accounting further, please contact David Schleicher, CPA at firstname.lastname@example.org.