June 04, 2018 Baker Tilly | Travis Gonzalez, Writer
New accounting rules are changing the way businesses go about disclosing lease activity in their financial statements. Under ASC 842, which takes effect for publicly traded companies in 2019 and for private companies in 2020, businesses will be required to include operating lease commitments and the related right-of-use assets as part of their reported debts and assets. This new accounting standard update will require organizations that lease assets, or lessees, to recognize on the balance sheet the assets and liabilities created by those leases. For heavy lease users across the retail, airline, manufacturing/distribution and construction sectors, the new standard will have significant implications. It will impact not only how company indebtedness is reported in financial documents, but also how these businesses go about recording and tracking leases, and whether they will be inclined to buy or rent assets in the future. “As public and private companies start to come off implementation of the revenue recognition standard effective in 2018 and 2019, they are focusing on the new lease standard and realizing that, depending on the number of leases, this can be a big effort to get to a point where they have fully implemented the new standard,” Baker Tilly partner and CPA Katherine Wiernicki said. Under the new guidance, a lessee will be required to recognize assets and liabilities for all leases with lease terms of more than 12 months. Consistent with Generally Accepted Accounting Principles, the recognition, measurement and presentation of expenses and cash flows resulting from a lease will depend on its classification as a finance or operating lease. The latter, formerly known as capital leases, constitute leases in which the lessor only finances the leased asset, and all other rights of ownership transfer to the lessee, effectively resulting in the purchase of a fixed asset. The former is a contract that allows for use of an asset but does not convey rights of ownership of the asset. Unlike current GAAP, which requires only capital leases to be recognized on the balance sheet, the new standard will require both types of leases to be recorded on the balance sheet. The goal of ASC 842 is transparency, Wiernicki said. A lease is a legal obligation to make payments in the future for the use of an asset or property. In the past, the information on future commitments related to those obligations was relegated to the footnotes of a company's financial statements. The new standard will require additional disclosures to help investors and other financial statement users better understand the amount, timing and commitment of cash flows arising from leases. These disclosures include qualitative and quantitative requirements, providing additional information about all leasing activity now recorded in the financial statements. “Even though in the past you disclosed the future minimum rent due under operating leases in the footnotes, those amounts will now be quantified and included in the balance sheet,” Wiernicki said.
This could immediately impact companies, causing them to appear more leveraged than before, and giving investors and lenders a deeper insight into the financial riskiness of the business. Air France-KLM's reported net debt is €3.7B, for instance, but its lease-adjusted net debt is €11.2B. The new lease accounting standards could also encourage some businesses to buy versus renting property or assets. This is especially true for health systems that rent facilities or medical equipment. Without the benefit of keeping leases off their balance sheets, it would make more sense for health systems to finance new equipment or space rather than leasing it. That has become increasingly common as health systems hire physicians and purchase medical office buildings. On the retail side, sale-and-leaseback arrangements might no longer be a desirable way for companies to quickly gain liquidity. If the rented floor space stays on the balance sheet, selling off corporate assets might become less attractive. Another approach may see some companies embrace shorter lease terms to minimize balance sheet liability, popularizing assets like flexible office space. Companies need to adjust to the new accounting standards sooner rather than later, Wiernicki said. Companies must first capture all their leases and then determine what tools they have available to help with compliance. Companies that have operating leases and have not thought about the recording of additional liability and the right-of-use asset are also going to have to figure out how to comply with the standards, and businesses need to be aware of how the changes to their balance sheets will affect existing debt covenants between themselves and their lenders. If a company does not have the resources to conduct a thorough analysis of their leases and adjust their records accordingly, bringing in a third party could help the business comply with the new accounting standards. That is where professional providers like Baker Tilly come into play, by helping companies understand the level of effort and the resources required in implementing the new lease standard. “As with every type of change in accounting, it takes a little time and help to implement and understand,” Wiernicki said. “These changes came out far enough in advance that as long as people are focusing on what it means to them, it will become business as usual. The next couple of years is where the heavy lifting will be done. But companies need to have a project plan in place.”