How impending changes to accounting for operating leases will affect your business

How would this impact financial reporting?

If and when this becomes effective, you would record a right-to-use asset and related liability as separate lines on the balance sheet.

This would also impact the statement of cash flows. Currently, under U.S. standards, operating leases are considered a period expense. That means that lease payments are considered a cash flow from operating activities, as they are just included in net income. However, under the new proposed standard, it would be similar to a capital lease — you would have payments on the lease reflected as cash flows from financing activities as opposed to operating activities.

Other factors to consider are the challenge of estimating the most probable lease terms/extensions and contingent rentals. These can affect current income if you don’t get it right upon adoption of the proposed standard.

If you have financial statements that have disclosures, you would be required to disclose in a table the changes in the asset and related liability from the beginning of the year to the end of the year in the footnotes.

In addition, especially with small businesses, it could impact financial ratios and in turn have an impact on the loan covenants a small business may have with their bank. So businesses may want to look at renegotiating their loan covenants with their bank. This would have an impact on leverage ratios and working capital ratios because you are essentially recording current liability for the current piece of this lease whereas under current rules, you’re not recording a liability at all.

So again, companies may want to talk to their banks about renegotiating those loan covenants. It will also have a positive impact on earnings before interest, taxes, depreciation and amortization (EBITDA) because you are capitalizing an asset as opposed to directly expensing it in the current period through lease expense.

When should businesses begin preparing for this?

Again, it is a proposal. There has been no effective date that has been announced. 2013 is realistic, however, it would be adopted retroactively. That means the earliest period presented in your financial statements would have to be adjusted for the adoption of this new standard. Companies should be prepared to account for this as of January 1, 2012.

What should businesses do to prepare for this?

We are recommending our clients evaluate all leases and determine whether or not they have a liability there, and that any modifications to existing leases can be properly evaluated and recorded.

In addition to determining the financial impact on your ratios, it’s also important to review your existing capitalization policies. If you don’t have one, there might be a threshold where you can capitalize everything over a certain amount but expense everything under that amount. If companies set that amount, you may avoid an undue burden for leases on smaller items like office copiers and such, where you may be paying a minimal amount per month, which may fall under the threshold of your capitalization policy.

Finally, we recommend our clients assess the impact on their tax accounting as well, because it will create another difference between what we call ‘book and tax.’ So what you capitalize for financial statement purposes is not necessarily capitalized for income tax purposes.

James C. Suttie, CPA/ABV, CVA, is a principal with Skoda Minotti. Reach him at (440) 449-6800 or [email protected].