Yes, the rumors are true. After years of talking about the impending changes related to Accounting Standards Update 2016-02 – Leases (Topic 842), private companies now have no choice but to look the standard square in the eyes and address. So, what does that actually mean?
First, let’s set the table a bit. This change pertains to any business that is required to produce what we call Generally Accepted Accounting Principles or GAAP financial statements. Most often, the driver for these types of financial statements is a request from a lender in connection with debt agreements or from other third-party entities.
Historically, when producing GAAP financial statements and evaluating leases you ended up with two options, either a capital lease or an operating lease, depending upon whether or not the lease met certain criteria. The result being, if the lease was capital, the related asset landed on your balance sheet and would be amortized over the life of the lease. And on the other side of the coin, you would book a capital lease liability that would be reduced via payments during the life of the lease. If this sounds familiar, its fairly similar to how one would account for a purchase of an asset via a loan. If the lease wasn’t deemed capital, then it would be considered an operating lease. This means no asset and no liability on the balance sheet. Instead, when lease payments are made it would show up as an expense on a company’s income statement and, as required by GAAP, the company would disclose these leases in the footnotes to their financial statements and include how much they are required to pay over the next few years.
Pretty straightforward right? Everyone’s used to it, so why change? There is actually a reasonable rationale for mixing things up. A main driver for being required to produce GAAP financial statements is to help ensure that when users of financial statements are looking at company A vs company B, they can feel confident that accounting rules and principles are being applied consistently and the resulting numbers and disclosures are comparable. This apples-to-apples comparison is critical for users and their decision-making. The way individual leases are being constructed and this old approach often times led to substantially similar entities having significant differences in their lease accounting. One may have huge balances on their balance sheet related to leases and other may have just about all their leases “off-balance” sheet, making comparability a challenge and resulting in very similar entities looking very different.
Now with the table being set, what exactly are these changes we are talking about? For this article we are going to keep this fairly high level, but the gist is this – A capital lease is now called a finance lease and is still accounted for on the balance sheet. We still have operating leases, but these leases are now also on the balance sheet. Before you ask, if they both go on the balance sheet, why have two different types, and how are they still different – we still have the concepts of a business keeping an asset at the end of a lease (finance) or returning the asset at the end of the lease (operating) and that detail is important to disclose. Beyond that the difference is mostly about how each presents the associated expenses on the income statement. For a financing lease, the amortization expense related to the asset (referred to as a right-of-use asset) is shown separate from the interest expense associated with the reduction in the lease liability. Then for an operating lease, the costs associated with it are recognized as one line item, lease expense, utilizing a straight-line approach of all these costs over the life of the loan. These two approaches result in finance lease related costs generally being larger on the front end of a lease compared to an operating lease with similar terms because of larger interest payments at the onset of a finance lease compared to the end.
To summarize, the effects of the new lease standards will result in a larger balance sheet as well as some significant work for businesses. Companies will need to begin analyzing their leases NOW and accounting for them in accordance with the new standards. A real time approach is far more favorable then waiting until after the end of the year. We can no longer delay the inevitable. The other potential ramification of these changes is to a company’s financial ratios and resulting debt covenant calculations. Many current debt agreements were created without this lease change in mind. Yes, we are adding both new assets and liabilities on the balance sheet, but all is not equal. There will be a current portion of the lease liability that will need to be reflected while the entire asset will be deemed non-current. This can mean dramatic changes to current ratios, debt to equity ratios and the like.
So, while “doing the work” internally, start having conversations with your lenders NOW as well. See about amending agreements for these covenants or having discussions with your lender around carving out the requirement to adhere to the new standard when producing your GAAP financial statements. Like a cruise ship, financial situations and agreements don’t change on a dime, time is needed to adapt and adjust. Don’t get caught and become overwhelmed this time next year, address this change head on. And if you need help, as always, the team at Meadows Urquhart Acree & Cook are here to help.
