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New Lease Accounting Standards
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By Mike North

 

No accounting issue in recent memory has been in discussion longer and more highly anticipated, than the Financial Accounting Standard Board’s (FASB) leasing project.  In February of 2016 the FASB released the long awaited accounting standards update (ASU 2016-02, Leases).  The standard will be effective for non-public companies, beginning with their 2020 calendar year-ends.  There have been several steps taken by the FASB to make the transition for companies as least painful as possible. 

 

The core principle of the project has always been that lessees recognize asset and liabilities associated with leases. The new standard does provide in general that, lessees recognize assets and liabilities on their balance sheet for leases of more than 12 months.  I will summarize key take-always for the leasing industry in this article, but the entire accounting standards update (ASU 2016-02) is available at the boards’ website, www.fasb.org

 

Existing accounting rules require lessees and lessors to classify their leases broadly as “Capital” or “Operating Leases” and account for those differently.  The new standards will continue to require a classification of leases, but now either as Finance Leases or Operating Leases.  The classification criteria is very similar to today’s bright-line test, but the new standards no longer require these bright line tests.  In general, you can expect finance leases under the new standards would have been capital leases under the old standards and operating leases under the new standards will have been classified as operating leases under the old standards. 

 

One area that has remained largely unchanged is lessor accounting.  There is very little change in lessor accounting under the new standards.  You should expect in almost all cases for your accounting to be identical as a lessor under the new standards as it is today.

 

Leases classified as finance leases under the new standards were likely classified as capital leases in the old standards.  These leases were on the lessee’s balance sheet as a capital leases, thus the accounting will be very similar under ASU 2016-02.  The key difference will be leases classified as operating leases.  These leases will now require the lessee to record the present value of the minimum lease payments as a liability and an equal asset on its balance sheet.  Essentially creating a gross up of balance sheets across the country that could total in the trillions of dollars.

 

What impact will these new standards have on lessors?

 

To the extent you are selling off-balance sheet treatment as a reason to finance through operating leases there is a need to reassess the way you are approaching customers.  Although an operating lease will require a liability to be recorded on the balance sheet, depending on the term of the lease and the size of the residual, that liability could be much less than if the customer were to borrow and buy the asset.   This is due to the fact that the operating lease liability is only the present value of the minimum lease payments the lessee is likely to make.

 

There may also be more requests from lessees to bifurcate other services (warranty, maintenance contracts, insurance) from the lease contract.  These ancillary costs can be bifurcated from the lease contract as including this cost as a part of this lease can increase the lease liability that would be recorded on the balance sheet.    

 

Debt covenant calculations may also be a concern for many leasing customers.  The requirement to record a lease liability on the balance sheet may impact certain common banking ratios.  One key comment that FASB made in their basis for opinion of ASU 2016-02, indicated that the FASB did not believe this lease liability should be considered “Debt”.  Instead, they would consider it an “Operating Liability”.  This could be relevant as one very common ratio for banking covenants is a debt to equity ratio.  Considering this lease liability as an operating liability, may mean it would not impact the debt to equity ratio. 

 

Although the new leasing standards may seem overwhelming at first, we do not expect them to be overly burdensome to lessees.  Although it will be important for lessors to understand the impact this standard swill have on their customers, many of the key benefits leasing provides to customers will remain unchanged.  Leasing as a manner of financing purchases will continue to serve an important role in the world economy.

 

See Mike North at the 2017 Annual Conference!

Thursday, April 6th
9 AM - LHPH | Tax and Financial Accounting Issues
10:15 AM General Session | Tax and Financial Accounting Issues Impacting Leasing

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