Earlier this month, the Financial Accounting Standards Board (FASB) issued its long-awaited new lease accounting standard. In a significant change from existing practice, most leases will now be recognized on the balance sheet as a liability with a corresponding right-of-use asset. Significant changes resulting from this standard are limited to the balance sheet and financial statement disclosures. Lease expense recognition is not expected to significantly change from existing practice nor are the removal of existing bright line tests for lease classification expected to significantly impact current and future lease classification conclusions.
The effective date of this standard is the annual period beginning after December 15, 2019 (calendar year 2020). Earlier adoption dates are required for public business entities and, in limited situations, not-for-profit or employee benefit plans with certain characteristics. However, for those who issue comparative financial statements, presented prior years will be required to retrospectively reflect the new guidance. No relief through the FASB Private Company Council from application of this standard is expected.
What is the Impact?
The new standard primarily changes accounting for operating leases. Although prevalent as a critical business financing tool, these leases have not historically garnered significant attention in the financial reporting processes of a company as they were merely disclosure items. The new standard will change this perspective and require greater focus be placed on balance sheet recognition for what were historically considered off-balance sheet arrangements. Specifically, this change will have the following potential impacts on a company with significant leasing activities:
- Increased management decisions: The new standard requires the application of judgement and estimation. Although conclusions are not expected to significantly change as a result of the elimination of the existing bright line tests and requirements to assess lease term and bargain purchase options, such judgements may receive increased scrutiny from stakeholders and auditors.
- Lease data collection and management: Determining the effects of this new standard on your company requires a complete understanding of your leasing activities; ensuring completeness and accuracy of lease data is paramount for an accurate implementation. Determining the appropriate lease liability requires collecting and evaluating various lease components including variable payments, lease term options, purchase options and non-lease operating costs. Many companies do not have sophisticated, centralized leasing functions therefore significant time and effort could be required to manually gather and summarize relevant lease information.
- Financial statement metrics: Because of the impact on the balance sheet, deterioration of debt ratios and return on assets could occur resulting in changes in the way stakeholders view the company’s financial performance. Debt covenants and compensation arrangements could also be impacted negatively by the effects of the new standard. Companies may be required to negotiate with their creditors for changes in existing financial covenants or agree to continue the use of existing lease accounting methods in calculating covenants. Similarly, key metrics underlying compensation arrangements may need re-evaluated.
- Lease negotiation: While companies should not make business decisions based on accounting results, they should be aware of the accounting consequences. Shortening of lease terms or higher proportions of variable payments may result in smaller lease liabilities, but do not provide security of long-term use of the asset. Companies will need to balance these considerations along with options to simply purchase the asset.
- Income taxes: Adoption of the new standard will result in additional tax-related impacts. These include impacts on deferred tax assets, property apportionment factors, and state franchise tax factors.
How You Can Prepare
Although the effective date seems to be far in the future, implementation of this standard will generally be overlapping with the implementation of FASB’s new revenue recognition standard. Because of this, companies should begin responding to this new standard sooner rather than later through the following methodology:
- Understand the new standard and monitor changes in interpretation that are naturally expected to occur.
- Create a cross-functional implementation team (e.g. finance, legal, operations, human resources, I.T.) and plan to implement the new standard.
- Identify and communicate with stakeholders regarding the potential impacts to financial metrics, covenants, and other agreements (e.g. compensation).
- Populate lease data and establish required judgments, estimates and accounting policy elections.
How HBK Can Help
HBK’s multidisciplinary team of accounting, tax and valuation professionals are available to assist in assessing how the new leases standard will impact you. Existing attest clients will receive training services on the technical aspects of the new standard as well as advice on project management and planning. Further assessment and implementation services are available to non-attest clients.