New Accounting Standard Shifts Lease Commitments to Balance Sheet

By: Paul Speidel, CPA; Pawel Szeliski, CPA; and Andy Klocek, CPA

The Time is Now to Begin Compliance

A new accounting standard will fundamentally change the way leases are accounted for on financial statements, and after years of delays the deadline for private companies and non-profits to comply with the standard is upon us – December 31, 2022.

The Financial Accounting Standards Board (FASB) approved Accounting Standards Update 2016-02 Leases (Topic 842) in 2016, issued numerous amendments and delayed implementation for private companies and non-profits several times, most recently due to the COVID-19 pandemic. The standard was adopted by public companies in 2018.

Private company financial statements for 2022 (technically, years beginning after December 15, 2021) must reflect the new lease accounting standard. Businesses will not only need to change their lease accounting reporting for everything from office space to copy machines, but they also will need to address strategic questions about how to prepare for the changes in a way that minimizes the risk of noncompliance.

For most private companies that lease their facility and perhaps equipment and vehicles, the impact may or may not be significant, likely dependent on the term of the facility lease and the amount of rent. However, the dollar figures may be large, and certain industries will feel a much greater impact. In particular, the construction and freight industries lease large amounts of equipment and vehicles. The most challenging part for businesses will be inventorying and gathering the required leases.

Lease Commitments on Balance Sheet

Specifically, the new standard requires companies to book long-term lease commitments as both assets and liabilities on their balance sheets, based on legally enforceable terms. “Long-term” leases are defined as those longer than 12 months. Under previous U.S. generally accepted accounting principles (GAAP), most operating lease commitments were disclosed in the footnotes to the financial statements, not recorded as assets and liabilities, unless they qualified as “capital” leases (lease-to-own transactions).

Reflecting lease commitments on the balance sheet is intended to more accurately communicate a company’s financial position. Future rental costs under lease obligations (operating and financing) now are reported as a liability, with the corresponding right to use the equipment or space recorded as a “right of use” asset. Operating leases continue to be charged to rent expense on the income statement, while financing leases (formerly called capital leases) continue to be amortized between principal and interest.

The new reporting standard – ASC 842 – applies to entities that enter into leases and subleases of property, plant and equipment, but does not apply to:

  • Leases of intangible assets
  • Leases to explore for or use resources such as minerals, oil and natural gas
  • Leases of biological assets such as timber
  • Leases of inventory
  • Leases of assets under construction

Ramifications Should Be Considered

The change in the standard has ramifications that businesses and lenders should consider. While the reporting changes will not directly affect how business is conducted, they may have a significant impact on financial reporting, including financial ratios and reported assets and liabilities.

Leasing is often a cost-effective or cash flow-effective alternative to purchasing or financing equipment or property, enabling businesses to expand, obtain equipment and rent space at a lower cost than outright purchases or other financing alternatives. Leasing also frequently offers tax advantages.

In the past, the ability to finance expansion and physical space without booking liabilities on the balance sheet aided companies in accessing lower-cost bank financing for other operating needs.

Implications for Businesses, Investors and Lenders

Now that all lease obligations that extend longer than 12 months are shifted onto the balance sheet, the implications could be significant, particularly with regard to companies’ relationships with investors and lending institutions. The implications include:

  • Assets and liabilities will increase based on the present value of the expected future lease payments.
  • This will cause an impact on current ratios, capital ratios and calculations of leverage.
  • The resulting asset and liability will be amortized into operations over the period of use (lease term including expected renewal options).
  • The lease “right of use” asset will be considered by financial statement users and investors as an intangible asset.
  • Credit ratings may change and debt covenants with lenders, if not rewritten to accommodate the new accounting requirements, may be violated, triggering loan defaults.
  • Consideration for the accounting treatment of unwritten or informal related-party leases.

How to Prepare

Companies with significant lease obligations, such as construction contractors and freight forwarders, should already have begun evaluating the effect of this accounting change on their financial statements, and all business owners should discuss with their advisors and lenders how to make this transition with a minimal impact on their creditworthiness.

While compliance with the new lease accounting standard may seem daunting at first, KRD utilizes lease accounting software to help ease the transition for our clients.

Leasing may remain the most cost-effective financing option for many businesses, but this change in accounting rules makes clear that the decision to lease can no longer be influenced by the expectation of favorable accounting treatment.

Contact your KRD advisor to discuss your next steps in preparing for the new lease accounting standard.

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