New Lease Requirements for Lessees
Scandals in the last several decades, such as Enron, have caused accounting organizations throughout the world to take a look at the way leases are reported or not reported on the financial statements. As a result of these studies, the Financial Accounting Standards Board (FASB) is revising their standards on lease reporting. FASB released Topic 842 Leases on February 25, 2016 which requires essentially all leases to be reported on the balance sheet. This is to stay in line with the new International Financial Reporting Standards (IFRS), new release IFRS 16, which was released in Jan 2016 and will be effective Jan 2019.
One issue brought forward by the Enron and other similar scandals, was a loophole in Topic 840. This allowed for operating leases to be reported as off balance sheet transactions. Up until now, only capital leases, such as equipment leases, were required to be reported on the balance sheet after meeting certain criteria. Operating leases, such as office leases under current generally accepted accounting principles (GAAP), only needed to be disclosed in the notes to the financial statements. As a result, there were large numbers of debt not being reported on the balance sheet. This “missing” debt can significantly affect investors’ decisions.
Topic 842 will supersede Topic 840 and address these issues. Capital leases will continue to be accounted for and reported the same as in Topic 840. Operating leases will be affected by this new standard. What does this mean for lessees’ (i.e. renter’s) financial statements?
Operating Leases Reporting Changes for Lessees
Operating leases with a term greater than twelve months will now be required to be reported on the balance sheet and not just disclosed in the notes. The operating leases will be required to be reported on the balance sheet as a right-to-use asset and an offsetting lease liability. The initial liability amount will be recorded at present value which will be allocated on a straight line basis for the life of the lease. All cash payments will need to be recorded on the statement of cash flows.
For operating leases with a life of twelve months or less, an election may be made to treat the lease as an expense on the income statement instead of recognizing it on the balance sheet. If this election is made, the lessee should use the straight-line method to expense the lease over the lease term.
The lease will continue to be disclosed in the notes to the financial statements. The disclosures should include (not a comprehensive list) the terms of the lease, options to extend or terminate the leases, any restrictions, leases which have not begun but create significant rights and obligations, etc.
What is the Impact?
While we may not be able to predict the full impact of these changes, one area which will be affected is the financial ratios. By reporting liabilities which previously were not reported, the company’s balance sheet will change a company’s ratios. Ratios most affected would be the working capital, current ratio, quick ratio, and debt to equity. These ratios most likely will make a company’s balance sheet look weaker. The reality is the company isn’t weaker than the year before, but is reporting what was not reported previously – leases. These ratios could affect a company’s borrowing costs as lenders will look at these ratios to determine risk.
Implementing the Changes
Topic 842 will take effect for reporting periods beginning after December 15, 2018 for public companies and December 15, 2019 for private companies.
This is the time to plan ahead. Since these changes will affect your ratios, take time to talk to your CPA to plan ahead. It may be time to rethink using leasing instead of purchasing.
While this deadline seems a ways away, it is really right around the corner. The task of changing how leases are reported can be daunting. Time will need to be spent in determining how to categorize leases, the amounts to be reported, and what should be disclosed. It is often recommended to begin implementing new changes before the effective date. This gives financial statement preparers time to work out the kinks. This is definitely something which should be taken to your CPA. Waiting until the time is almost up, may result in the delayed release of your financial statements due to your accountant being swamped with the changes.
Contributed by Jamie M. Shryock, CPA