Changes to the financial reporting of leases by the Financial Accounting Standards Board (FASB) is a decision that is more than 10 years in the making. The new standards require businesses to record all leasing arrangements on their balance sheets while also better aligning U.S. and international financial reporting standards.
Public companies, some nonprofits and some employee benefit plans with annual periods beginning after Dec. 15, 2018, have already begun implementing the changes. All other calendar-year entities will need to adopt the new rules for annual periods beginning after Dec. 15, 2019. Doing so is not just a matter for accounting departments. These changes could potentially trigger loan covenants or otherwise make it necessary to revisit existing banking agreements, as the underlying basis for these financial relationships are likely to be impacted.
Smart Business spoke with Eric J. Schnieber, a shareholder at Clark Schaefer Hackett, about the changes to the financial reporting of leases and what companies need to know about their impact.
What are the new standards and how do they differ from the previous standards?
Under the old rules, capital leases, recognized as a form of term financing, hit balance sheets as both an asset and liability. Operating leases, which generally represented a stream of rent payments with no transfer of ownership, were only required to be disclosed in financial statement footnotes, a practice commonly referred to as off balance sheet financing. These inconsistencies created heartburn for many users of financial statements.
Under the new standards, all leases will need to be recorded as a right-of-use asset with an offsetting liability on a company’s balance sheet. And that is a big change.
What will be the effect of these changes?
There is very real concern by some companies that these newly reported liabilities could have a significant impact on their financial statements (hundreds of thousands or even millions of dollars). Changes that significant will alter the complexion of a lot of balance sheets, which will impact the way banks and other financial institutions look at the debt profile and overall financial risk of a company.
It is not all negative, though. The new standards are more consistent with those of foreign company financial disclosures. That could put U.S. companies seeking foreign direct investment in a better position to access new capital markets because foreign investors are more comfortable with the clarity the new standards offer.
What should CEOs understand about the effect of these changes?
CEOs should concern themselves with understanding what new liabilities will appear on their companies’ balance sheets. There is a chance that the changes could impact debt covenants, in which case a conversation will need to be had with the bank about amending those agreements so the company’s access to capital is not negatively affected.
There is also the chance that a company’s increase in liabilities could substantially affect its debt-to-equity ratio or fixed-charge coverage ratio, and that also may impact a company’s access to capital, or at least drive up the interest rate that is being applied.
How can CEOs mitigate the impact the changes will have on their companies?
Companies that are reliant on leasing should prepare to talk with their banker(s) and other stakeholders by first having a conversation with their accountant. Accountants have significant knowledge on the topic and can help companies create a strategy before conversations with lenders are had.
An accountant will help a company develop an analysis of its financial position given the standards changes and make clear the expected year-to-year effect the changes will have on the company’s balance sheet. From there, the company and its bank can discuss how those changes will affect the banking relationship and negotiate a plan.
Time is running out, so start the implementation process now. Waiting until December 2019 could prove costly to companies from a financing perspective and would likely cause significant delays in financial reporting.
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