What seemed like a topic that was always in the distant future is now upon us: accounting standards update (ASU) No. 2016-02, Leases(ASC 842).
Under previous rules, lessees typically accounted for lease transactions as off-balance sheet operating leases or on-balance sheet finance leases. Under the new standard, lessees will have to recognize nearly all leases on the balance sheet.
ASU 2016-02 comes on the heels of Revenue Recognition (ASC 606) and presents another wide-reaching and major change to the accounting world. Under ASU 2016-02, balance sheets will swell as nearly all leases will now be capitalized. Overall the ASU is very complex; however, below are some frequently asked questions that we are seeing from our clients and the industry. Like most things, the devil is in the details, but the below Q&A can provide high-level answers to these burning questions.
1. When is the standard effective?
ASU 2016-02 is effective for public companies in 2019 and private companies in 2020.
2. What are the changes to how capital leases (now known as “finance leases”) are presented?
The general accounting for finance leases remains largely unchanged compared to the legacy presentation of capital leases.
On the balance sheet, the finance leased asset is typically recorded as part of property, plant and equipment (PP&E), and the lease liability is recorded as funded debt. From a profit and loss perspective, the leased asset is depreciated over the shorter of the term or asset’s useful life, and interest expense is front-loaded as the lease obligation is amortized.
3. How will operating leases now “look” on the balance sheet?
Operating leases take on an entirely new look under ASC 842 in that a right-of-use (ROU) asset and liability are recorded by calculating the present value (PV) of the lease payments using the appropriate discount rate.
Balance sheet presentation of a ROU asset is classified as a long-term asset on a separate line item outside of PP&E. Furthermore, the ROU lease obligation will need to be separated into short-term and long-term liabilities that are aside from funded debt. The profit and loss components of a ROU asset and corresponding liability are amortized under the straight-line method and presented together as rent or lease expense.
Under ASC 842, neither amortization of the ROU obligation nor the ROU asset is considered interest expense or depreciation expense, leaving EBITDA unchanged from accounting for operating leases under the prior lease standards.
4. Does the standard change the way we determine which type of lease we have?
There will continue to be two types of leases: finance (formerly known as capital) and operating. However, both will require recognition of an asset and a liability on the balance sheet. The differentiation between the two types of leases will play a significant role as to balance sheet classification but does not come without significant analysis in determining what type of lease it actually is.
Finance leases will no longer be evaluated using the “bright-line” tests. Rather, they will be evaluated using principles-based criteria, which aim to evaluate the underlying substance of the lease. The principles-based criteria certainly involve a level of subjectivity; however, the finance lease classification applies should any of the following be met:
- The property transfers to the lessee at the end of the lease.
- The lessee is reasonably certain to exercise a purchase option.
- The lease term is for a “major” part of the asset’s economic life.
- The present value of lease payments equals or exceeds “substantially all” of the fair value of the asset (undoubtedly the most subjective — more on this later).
If the lease does not meet the above criteria, it will be considered an operating lease.
5. What changes for lessors vs. lessees?
From the lessor’s point of view, not much changes. In contrast, lessees will now be required to capitalize all leases with terms greater than 12 months.
6. Why is the FASB doing this?
Think about this: Prior to this standard, airlines had not been recording their airplanes on their balance sheets! The standard provides better clarity to users of the financial statements via recognition and measurement of a company’s leased assets and associated liabilities that have historically been tucked away in a footnote disclosure.
7. How do I determine the discount rate?
This is where things can get tricky! To determine the PV, lessees should use the implied rate in the lease contract (if known) or the company’s incremental borrowing rate. This rate is based on what rate the company would obtain if financing 100% of the underlying asset using similar terms and pledging the asset as collateral.
Knowing that this is often difficult to determine, private companies are afforded an election to use the risk-free rate (e.g., Treasury bill). However, this comes with caution as it typically results in a higher PV, leading to a larger corresponding asset and liability to be booked.
8. Are there new disclosures required?
The footnote disclosure under current standards doesn’t afford financial statement users with many details on either type of lease; however, this is changing. Under ASC 842, the disclosure will provide the reader with both quantitative and qualitative information as to how the lease classification was determined. This information will help the reader comprehend significant judgments and assumptions that were used in evaluating leases under the principles-based criteria.
9. How will this impact my loan covenants?
With operating leases now on the balance sheet, various financial metrics, including those commonly used in loan covenants, are sure to change. The measures of working capital, quick ratio, current ratio and any metrics related to debt (i.e., funded debt) will need to be reviewed carefully to understand how newly capitalized leases will influence results.
In calculations involving EBITDA, the change should not impact results as interest and depreciation (associated with finance leases) are added back, and operating leases (presented as rent or lease expense) are commonly excluded from the benchmark.
Needless to say, it will be imperative to be proactive with your banker. Covenants should be analyzed to determine the impact of the new standard. Some lenders are changing agreements to use updated metrics, while some are simply adding wording to the covenant calculation that says, “Under GAAP in place as of the date of this agreement.” That may seem to simplify things; however, it may also require you to keep two sets of books and records, which can get complicated.
10. How do I prepare for these changes?
The first step is to digest the change in standards and the ripple effect that will come from capitalizing substantially all leases. This will involve an evaluation of the appropriateness of systems, procedures and controls necessary to accumulate and track pertinent lease information. Determination will need to be made as to adoption of ASC 842, which is available on a modified retrospective basis or through a cumulative effect adjustment as of the beginning of the year of adjustment.
A proactive approach to the change in lease accounting is certain to help reduce the burden and headaches of another significant change in accounting standards. If you haven’t done so already, you should start your process in a variety of ways, including knowledge transfer sessions, the evaluation of lease contracts and interpreting the impacts on financial statement presentation and disclosures.