After years of debate, the Financial Accounting Standards Board (FASB) issued an Accounting Standards Update (ASU) intended to improve financial reporting about leasing transactions. This change affects all companies and other organizations that lease assets such as real estate, airplanes and manufacturing equipment. This leases standard is the culmination of years of debate on how to make balance sheets better reflect companies’ true liabilities.
The FASB’s new lease accounting standard goes into effect for public companies in 2019 and non-public entities in 2020. This new standard will require businesses to record assets and liabilities associated with renting office space, heavy equipment, and fleets of vehicles on their balance sheets. While most contracts that meet the identification of a lease today will most likely also be leases when the new standard comes into force, businesses will have to assess whether service contracts and other arrangements contain provisions that will also meet the new definition of a lease.
While this new standard may not seem like a big change, companies should evaluate the impact and plan accordingly as it could have an impact on your financial reporting metrics. The changes in ratios could affect how your stakeholders view your business and impact compliance with financial covenants.
To implement this new accounting approach, the first challenge is determining what is a lease and what is not. The standard defines a lease as a contract, or part of a contract, that conveys the right to control the use of a rented asset. The concept of control is a key change from current GAAP’s definition of a lease, and it means that the customer has both the right to substantially benefit from all of the economic benefits of the asset, as well as the right to direct its use.
While most existing leases will continue to be leases under the new standard, many more types of arrangements may be captured under the new lease definition and will have to follow the new accounting rules. There are many arrangements that may not be called a lease but will fall under the new definition. Businesses will need to review the legal documents and determine whether they are receiving a service or an asset. Some agreements will contain both, resulting in more complexity.
Under existing lease accounting rules, companies only have to record lease obligations on their balance sheets when arrangements are akin to financing transactions, such as rent-to-own contracts for buildings or vehicles. Few actually get recorded, however, because of what critics call “bright lines” in the rules that allow businesses to structure most deals to look like simple rentals. If an obligation is not recorded on a balance sheet, it makes a business look like it is less leveraged than it really is. Critics for years have said that a retailer that pays rent for hundreds of storefronts has just as many financial obligations as a retailer that takes out mortgages to buy them.
Early planning and analysis will be important for your financial reporting and users of this information. We recommend you consider this new accounting standard as you review, negotiate and enter into new contracts and financing arrangements in the coming years.