The current lease accounting standards have been in existence since 1977 under Financial Accounting Standards Board (FASB) Number 13. We are all familiar with these rules – generally, leases are expensed as payments are due (i.e. operating leases) unless you meet one of four specific requirements to show the lease on your balance sheet. These types of leases are known as capital leases, and require the leased asset to be added to the balance sheet and depreciated over the lease term. In addition, the full amount of future lease payments is presented as debt on the balance sheet and reduced as payments are made. In fact, many vendors are familiar enough with the lease accounting rules that they can structure the lease to meet the desired accounting treatment (i.e. operating or capital lease).
Over the years, much debate has occurred over whether traditional operating lease accounting “hides” liabilities from the public by keeping them off the balance sheet. As a result, effective for all calendar year 2020 financial statements, FASB has revised the lease accounting rules to address this debate.
The new rules still retain operating and capital (now called financing) leases. The accounting for financing leases is virtually identical to the old rules; however, the rules for operating leases have changed significantly. Operating leases will now be accounted for similar to financing leases:
- Record asset (“right-to-use” asset) and liability (debt obligation) for the present value of future minimum lease payments.
- Lease expense is recorded on a straight-line basis over the term of the lease. This results in the same amount of expense as would have been recorded under the old rules.
- The liability is reduced based on an amortization schedule allocating cash payments between principal and imputed interest.
- The asset is amortized over the term of the lease – this is not done on a straight-line basis, but is the resulting “credit” needed to balance the effects of the above journal entry.
The FASB did grant an exception to applying the new rules for all short-term leases of 12 months or less. Renewal options that are likely to be exercised must be considered when determining if it meets the 12 months or less criteria. In addition, any purchase options would preclude you from utilizing this exception.
The standard also includes many details regarding the definition of a lease, which amounts are included in lease payments, selection of a discount rate, lease modifications, subleases, build to suit arrangements, and other intricacies that often arise when dealing with leases. In addition, there are several new financial statement disclosures that will be required once the new standard is implemented.
Although the standard is not effective yet, it’s important to start thinking about it now. If you issue comparative financial statements, you will need to make the accounting changes for both 2019 and 2020. The lease changes may significantly change the way your balance sheet looks, to include the calculation of certain key ratios, such as working capital/current ratio.
Start by taking an inventory of all your current leases. Document the lease terms and provisions so you can begin comparing them to the requirements of the standard. If you are entering into any long-term lease agreements prior to these dates, you will want to understand if certain provisions in the agreements will change the accounting treatment under the new standard. You will also want to understand any regulatory provisions included in debt or franchise agreements, as well as how any granting agencies, bonding companies, etc. interpret financial statement ratios. It will be important to plan ahead so you can educate your financial statement users regarding the changes. Finally, you will need to consider any necessary software changes for depreciation – the amortization of the right-to-use asset is not based on current methodology and may not be able to be calculated within the software.
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