New Lease Accounting Rules Are Imminent

New rules related to accounting for lease transactions will take effect for private companies and not-for-profit organizations next year, and companies that have active leases should consider reviewing them this year before the change takes place. The accounting changes and effects on businesses are vast and will impact nearly every business in the country.

The Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2016-02 related to accounting for lease transactions, and issued an update in 2018. Last year, FASB delayed implementation, giving companies more time to prepare.

When Will this Become Effective?

The new lease accounting standards become effective during the calendar year 2021 for privately owned businesses and most not-for-profits. Publicly-held companies already are in their implementation phase. This transition is less than one year away for most businesses, and the groundwork for future repercussions is being set with each new lease signed; as any lease in place when the lease accounting standard becomes effective will require the same analysis as new leases, resulting in the recognition of an asset and liability.

This update requires companies to report most leases on their balance sheets and puts an end to the off-balance-sheet reporting of assets and liabilities related to the rights and obligations created by operating leases. While companies are currently required to disclose lease commitments in the footnotes of their financial statements, they will now have to add lease obligations to their balance sheet in addition to required disclosures within the footnotes.

Capital Leases vs. Operating Leases

At the present, there are two types of leases: operating and capital leases. Capital leases are typically treated as financing transactions, and under the terms of the lease, the lessee may immediately gain benefits of ownership and recognize the asset on the balance sheet as a capital asset.

Capital leases are very similar to debt because an asset is capitalized and offset with an obligation owed to another party. And like debt, it requires disclosures of interest rates, collateral, and future maturities.

All leases not meeting this criterion are considered operating leases. An operating lease is similar to a rental contract because the lessee pays fees for the life of the lease and returns the asset upon expiration of the lease.

As a result, operating leases have little effect on the financial statements, and only occasionally are considered within financial covenants under borrowing agreements.

Changes under the New ASU

Under the previous lease accounting standards, companies disclosed capital leases on their balance sheet, while other leases, such as operating leases, required no balance sheet disclosure. Under the new standards, operating leases will require recognition on the balance sheet similar to capital leases, but under different classifications.

Lessees will be required to recognize a “right-of-use” asset and a lease liability at the present value of all reasonably certain payments, which includes renewals, purchase options, etc.   The “right-of-use” asset will represent operating leases for computers, equipment, buildings, etc., which are greater than 12 months in duration at inception but do not meet the finance lease criteria.

This could potentially place a burden on management to determine the likelihood of lease renewals and other potential outcomes many years down the road.

These changes to lease accounting standards will affect your financial statements, bank covenants, and other business metrics, unlike anything seen in the past 20 years. You should consult with your financial advisor to see if these lease changes affect your business.