The Financial Accounting Standard Board’s (FASB’s) new lease accounting rules are having a significant impact.
Historically, U.S. accounting standards classified leases as operating or capital, but the criteria for differentiating between the two has not been consistently applied. This inconsistent application has made it difficult for end users to compare financial statements. Now, nearly all leases must be reported on the balance sheet as a liability and a corresponding asset or a right-of-use asset.
“This could impact more than just leases and will have ripple effects throughout organizations,” says Brad Eberhard, principal at Clark Schaefer Hackett. “For instance, people are looking at their service contracts to see if the contracts need to be considered under these new lease standards.”
“An IT service contract that identifies a server, for example, could fall under the new standard and need to be included on a balance sheet,” says Michael Borowitz, shareholder at Clark Schaefer Hackett.
Smart Business spoke with Eberhard and Borowitz about the changes to lease accounting and their impact on organizations.
Why was the change made?
The FASB sought to add consistency among reporting entities. It also moves U.S. accounting standards toward international standards, which adds increased uniformity.
End users felt financial statements were not always comparable and understandable, due to the subjective nature of applying the lease standards. The old lease standard essentially allowed companies to maintain a liability off the balance sheet, based on their interpretation of whether the lease was capital or operating. A company with a leased piece of equipment has received a service and has an obligation to pay, which is the definition of a liability. FASB concluded this as well and sought to move these ‘off balance sheet’ liabilities to the balance sheet.
When do companies need to be compliant?
Public companies have to comply with the new standard for periods beginning after Dec. 15, 2018, which impacts their current financial reporting. Private companies’ effective date starts with fiscal periods beginning after Dec. 15, 2019.
The 2018 filings of large public companies can guide private companies, but private companies should determine now how this new lease standard fits into their operations. The biggest implementation burden will fall on companies with a large number of leases, including larger retailers that lease locations, businesses with leased machinery and vehicles, or companies with significant service agreements. Businesses must evaluate each lease agreement to determine the lease value and record the value on the balance sheet. Additionally, all future leases will need to be evaluated. Even with these complexities, implementation is solvable.
Do you expect the lease standard to change how companies operate?
As leases are renegotiated, terms may be shorter. A 10-year lease might convert to a five-year lease with a five-year renewal option. That places a smaller liability on the books by calculating net present value based upon five years. However, the standards require the lessee to consider all renewal periods in the net present value calculations that are reasonably certain of exercise.
Also, there could be instances where rather than attaching service agreements to a specified piece of equipment, they will describe general equipment usage.
What else do employers need to know?
Software can assist with the complexities of leasing operations and the required calculations. Private employers, however, may not yet realize how deep this could go because they have not thoroughly reviewed all of their contract agreements yet.
With the help of their accountants, employers need to track down leases and service agreements and begin to understand whether they are being reported correctly. They should stay tuned as amendments and technical corrections are issued.
Companies need to start educating internal financial departments, as well as others who deal with contracts, like operations managers and sales representatives. As new leases are signed, business leaders should consider the effect on future financial reporting. Also, it’s important to determine how balance sheet changes will affect bank covenants as additional debt is added to the books.
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