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CHANGES IN ACCOUNTING FOR LEASES

Leases are an important financing tool for many businesses. They allow companies to access the benefits from assets to accomplish strategic objectives without having to tie up cash flow in purchasing the assets. Businesses in almost every industry utilize leases in one way or another. For over 40 years, the accounting for leases has changed only slightly. But in February 2016, the Financial Accounting Standards Board (FASB) issued a standards update that drastically altered the lease accounting requirements, which will go into effect beginning with calendar year 2019 for public companies and 2020 for private companies (ASU 2016-02). The implications of this change effect any company involved in leasing, whether the company is publicly traded or not.

CURRENT LEASE RULES

Under the current standards, a lease is first classified as either an operating lease or a capital lease. The accounting for operating leases is straightforward and allows a company to account for the total amount of the lease payments as a simple expense. Most lease arrangements utilized by companies today are operating leases. Accounting for a capital lease involves more complexity because a company treats the leased asset as if it purchased the asset. In other words, a company carries the asset on its balance sheet and records a liability payable to the lessor. Rather than accounting for a lease expense each time a payment is made, the company recognizes interest expense related to the liability and decreases the outstanding value of the liability. At the end of each accounting period, the company also recognizes depreciation on the asset. The new lease standards will change this accounting and alter the classification of leases.

ACCOUNTING CHANGES

Instead of operating and capital leases, ASU 2016-02 requires classification of a lease as either an operating or finance lease. The change is targeted towards; only minor changes will be made to lessor accounting. The important change to the accounting for lessees is this: regardless of whether a lease is an operating or finance lease, a company must recognize an asset and a liability for the lease in its financial statements. For both lease types a company recognizes a “right-of-use” asset and a liability representing the present value of the total lease payments. If a company uses a finance lease, the company recognizes interest expense

on the lease liability and amortization expense of the right-of-use asset each period. The amount of total lease payments in excess of interest expense reduces the lease liability (similar to accounting for notes payable). Accounting for operating leases will be slightly different. With an operating lease, companies take the total amount of lease payments and recognize them as a lease expense on a straight-line basis over the length of the lease term.

EFFECTS OF THE CHANGE

All companies should understand the effects of the new lease standards on the financial statements. Over the term of a lease, companies will recognize the same amount of expense under either lease type. The biggest change made is that companies will recognize all leases on the balance sheet. By recognizing a right-of-use asset under financing or operating leases, multi-state companies may be required to allocate more income to some states for state income tax purposes. Many states require companies to apportion income to their state based on the amount of assets held in that state. Because all leases will require companies to recognize right-of-use assets, companies may need to allocate more income to states where these leased assets are located if that state requires apportionment by the amount of assets.

The new lease standards may also affect financing by banks. Banks commonly focus on financial ratios to help in making lending decisions. One particularly important ratio is the debt coverage ratio. The debt coverage ratio is commonly calculated as net income from operations divided by total current liabilities. This ratio tells banks the ability of the company to repay their debts in the near future. With additional debt carried on the balance sheet in the form of the lease liability, companies may find it more difficult to obtain financing than it is under the current lease regulations.

The FASB’s intent in releasing the new lease standards update is to more accurately depict the economic realities of lease transactions on the financial statements. While it is still undetermined if the updates coming in 2019 and 2020 will accomplish this purpose, the effects of this change will be widespread. All companies using, or planning to use, leases as a form of financing and securing assets should be aware of how they will be affected. Accounting experts at Davis & Bott can help with the additional information and/or analysis in making these decisions.