For decades, companies weren’t required to report many lease-related assets and liabilities on their balance sheet. That’s all changing under a new lease accounting standard issued in February 2016. The FASB Accounting Standards Update (ASU) No. 2016-02 (Topic 842) Leases has been in the works since 2010, but it is finally here and could have some major implications.
This update is a product of the joint International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) attempt to develop a new approach to lease accounting that would require assets and liabilities arising from leases to be recognized in the balance sheet. The standards boards disagreed on several aspects of the project—in particular, how leases should be reported on companies’ income statements—and published separate final standards on lease accounting in early 2016. However, both standards focus on providing greater transparency in reporting future lease obligations.
Shifting the Reporting Paradigm
Under the new guidelines, companies will be required to record assets and liabilities arising from a lease with a maximum term of more than 12 months. The concepts of “capital” and “operating” leases will remain in place, but both will now be recognized on the balance sheet. The only exception to the standard is for short-term leases and intangible leases.
The difference between the two types of leases in this new standard will be in how they are amortized onto the income statement as follows:
- Capital leases: Recognize a right-of-use asset and a lease liability, initially measured at the present value of lease payments. Recognize the discount on the lease as interest separately from the amortization of the right-of-use asset.
- Operating leases: Recognize a right-of-use asset and a lease liability, initially measured at the present value of lease payments. Recognize a single lease cost, combining the discount on the lease liability with the amortization of the right-of-use asset, on a straight-line basis.
Previously, companies considered various rules to determine if they had a capital lease or an operating lease. If these conditions weren’t met, the lease was generally considered an operating lease and the lessee simply recorded the payments as expenses on the income statement. These rules gave companies significant leeway to structure deals that looked like rentals. Investors and lenders often complained this practice makes lessees appear more financially secure than companies that take out loans to buy the same assets.
The standard will take effect for public companies for fiscal years, and interim periods within those fiscal years, beginning after Dec. 15, 2018. For all other organizations, the ASU on leases will take effect for fiscal years beginning after Dec. 15, 2019, and for interim periods within fiscal years beginning after Dec. 15, 2020. Early application will be permitted for all organizations. Lessor accounting under the new standard will remain similar to before.
Benefits of Implementing the New Standards
Despite the delay of these requirements, proactive telecommunications and utility companies should talk to a financial advisor today about how the lease standard is likely to affect their financial statements and debt-to-equity ratios in the future.
Companies should begin to draw up a plan to get ready for the new standard, even as they also work to implement FASB’s revenue recognition standard. Doing so can help preempt negative consequences related to this major change.
Start by taking an inventory of all your leases and determine how they align with the new standard. The key is to understand the gap between where you are and where you need to be when the guidelines become applicable. Then, work backward to where you are today to develop your plan of implementation.
A centralized record of your leases could lead to benefits for your company, rather than headaches. Under previous U.S. Generally Accepted Accounting Principles (GAAP), most companies may not have had full visibility into their leasing portfolio. By recording everything on your balance sheet, you have the opportunity to make better decisions, like how you handle the assets at the end of the lease.
Whether you choose to renegotiate leases, enter into short-term leases or decide to buy certain assets rather than continuing to lease them, you’ll have the ability to make decisions that may result in increased efficiency for your organization.
As always, we are here to help! Contact us to find out how our telecommunications and utilities teams can help your company comply with the new lease accounting standards.
Meet the Author
Josh Bailey, CPA
Aldrich CPAs + Advisors LLP
Josh Bailey joined the firm in 2008 and is dedicated to serving utility, nonprofit and governmental organizations, with extensive training in related accounting issues. He has experience with clients of all sizes and performs all aspects of the audit. He graduated from George Fox University, holding a degree in accounting and business administration with an…
- Audit and assurance