The proposed changes to lease accounting rules will soon have businesses scrambling to figure out how to comply.
“Although the changes have not yet been enacted, businesses need to act now to determine the potential effect of the proposed regulations in order to minimize the negative effect on the company,” says Tina Salminen, CPA, director in assurance services at SS&G.
“In the current GAAP world, you either have an operating or a capital lease,” says Salminen. “From a financial statement presentation perspective, businesses typically prefer operating leases as they are off balance sheet. However, because of various released and proposed changes, companies are required to disclose off-balance sheet risk in order to increase the transparency of financial statements, including the liabilities related to off-balance sheet leases.”
Smart Business spoke with Salminen about what businesses should be doing now to minimize the impact of the proposed new lease accounting rules.
Why is this change being made?
The goal is to make financial statements more transparent and to promote comparability of financial information.
As a result of this proposed IFRS/GAAP convergence project, there will no longer be an operating or capital lease classification, but instead there will be a ‘right-to-use asset.’ Under existing guidance, companies holding operating leases are not required to record the future liability on the financial statements. Thus, a user of financial information would not easily discern this lease and the associated cash flow risk that may exist.
Under the proposed guidance, it will be very clear that you have debt on your books and the asset associated with the debt will be readily apparent.
How will the change impact businesses?
Businesses that hold leases — either as a lessee or lessor — may have to change the way they account for these leases. The proposed changes affect everyone from the leasing agent who leases buildings to the business that leases operating equipment.
The most critical issue is to assess the effect of this pronouncement on your debt covenants. If you lease equipment and now have to record this equipment on your books, the results may impact your financial covenants and your ability to meet these covenants.
Another important effect of this potential pronouncement is that the resulting bookkeeping could be time and cost intensive.
What can business owners do now to prepare?
Businesses need to review the potential impact based on their current leasing situation. If your company is lease-intensive, talk with your lender now about rewriting covenants as you may be in a position under the new leasing rules whereby you will no longer meet them. Not addressing this now in the current risk-averse lending environment could result in the bank calling the debt or reducing the availability of lending to your company.
Most banks are only now beginning to realize the potential impact this proposed guidance will have. It is the company’s responsibility to plant the seed with the lending institution because it may not be an easy fix.
Another potential issue that may occur upon implementation is a significant short-term effect on expense. With operating leases, you make monthly equal payments and, therefore, you can budget for payments. Under the new guidance, the debt will typically result in much higher interest payments initially as the principle is paid down. From a budgeting perspective, this will result in a more significant financial hit initially due to interest expense.
How will it impact the way companies do business?
If you currently purchase capital assets, this proposed guidance will most likely not have much impact on your current financial position. However, if you are a lease-intensive business, you will need to start analyzing whether you should renegotiate current leases or purchase the related equipment.
One item to consider during this analysis is that when you purchase an asset, you have more flexibility with equipment lives. When you lease equipment, you are required to depreciate the equipment over the lesser of the life of the lease or the life of the related equipment. For example, if a company purchases a piece of equipment that could also be leased over 10 years, and decides to depreciate the equipment over 15 years as this better represents the useful life of the equipment, the annual financial effect to buy could be substantially lower than if the company were leasing the same equipment.
The financial impact of future leasing decisions will require companies to seriously consider purchasing versus leasing.
What will the impact be on building leases?
You may start to see shorter-term leases. A building lease for 15 to 20 years will be recorded as an asset and associated liability valued at its net present value of future minimum lease payments. This could reduce the amount of debt and the associated interest expense recorded on your books. What some companies should consider is negotiating shorter-term leases with more renewal periods. Thus, if renewal terms are not imperative to continued operations, the company would be able to record the future minimum lease asset and associated liability at a lower value due to this reduced lease term.
What would you say to business owners who will wait until this goes into effect to address it?
If you wait, it could be quite costly. I would recommend businesses start their analysis now to determine whether changes to leasing structures will be necessary. Taking a proactive approach may reduce the effect on your financial statement and debt covenants.
That also ensures a realistic budget, because if you want to continue leasing, you need to start budgeting for higher interest costs.
Tina Salminen, CPA, is a director in assurance services at SS&G. Reach her at (440) 248-8787 or [email protected]