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Preparing for New Lease Accounting Standards

Lease accounting standards are being revised for the first time in decades. If your organization leases property or equipment, the new rules will affect you — perhaps greatly. Here’s an overview of what is changing and how to prepare.

Balance sheet transparency

Two big changes are coming. First, firms will report all leases longer than one year on their balance sheets. Second, lease types are being redefined.

Generally speaking, there have been two main types of business leases: capital and operating. Capital leases appear on the balance sheet, while operating leases do not, though the related commitments are included in footnotes.

Under the new standards, all leases will fall into three categories:

  • Short-term: One year or less
  • Financing leases: Term is for a major part of the economic life or value of the asset
  • Operating leases: Term is not for a major part of the economic life or value of the asset

Any leases longer than one year, regardless of type, will be recorded on the balance sheet. They’ll appear as assets for leased “right-to-use” buildings, equipment and more, with offsetting liabilities for the lease obligations. Financing leases will be recorded in the income statement similar to current capital leases, while operating leases will be recorded in the income statement on a straight-line basis, similar to current operating leases.

The rules don’t become effective until 2019 for public companies and 2020 for private companies. However, public firms are required to show three-year comparative financial statements, so the new standards will require restatement of 2017 for them. Private companies typically report two-year comparatives to lenders, which will require restatement of 2019 for comparative purposes.

Context and impact

The intent of the new standards is to create more clarity and transparency by requiring uniform lease accounting treatment. In the past, gamesmanship often kept lease deals off the books. Firms would declare most or all of their leases as operating leases to keep significant debt off of the balance sheet, or structure what is essentially a long-term lease agreement as a short lease with multiple renewal options. Those days will soon be gone.

In practical terms, lessee accounting will change considerably, whereas lessor accounting will remain largely unaffected. Firms with significant property or equipment disclosed as operating lease commitments will likely experience substantial impact to their financial statements.

A big unknown is how bankers will react to the new debt obligations. Realistically, companies are essentially in the same economic position despite the new numbers recorded on the balance sheet. Still, lenders might need to reevaluate covenants and loan document provisions, as the new accounting treatment could alter debt-to-equity ratios and tangible net worth calculations.

Getting ready

Despite the extended effective date, there are steps your firm can take to prepare.

Review all current leases, determining which ones will be in effect when the standard becomes effective and which ones may need to be renewed.

Choose from transition options. Entities will have the option to elect a number of practical expedients relating to the classification of leases that commenced before the effective date and the ability to use hindsight in evaluating lessee options to extend or terminate the lease.

Consult your advisors and lenders. Make sure to discuss the new standards and any potential impact with your lenders or other users of your financial statements to avoid last-minute concerns or surprises.

Published in Audit & Assurance

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