Companies like AT&T and Delta Airlines are preparing for the debt on their balance sheets to jump by billions of dollars, thanks to a new accounting standard for leases. The Financial Accounting Standards Board (FASB) has issued its final update to lease accounting guidance, and what it means for you is that a lot of off balance sheet activity is soon to make its debut on the face of your company’s financials.
How accounting for leases will change under the new standard
Under current U.S. GAAP, leases are classified as “capital” (typically those of equipment and machinery for the majority of their useful lives) or operating (office space or short-term equipment, for example). Capital leases have the economic characteristics of ownership and are recognized on the balance sheet. Operating leases are recognized as rent or lease expense on the income statement.
The key change with the new standard is that all leases, regardless of class, with a term greater than 12 months must be recognized on the balance sheet with a right-of-use asset and an offsetting liability. Additionally, the bright lines tests to distinguish between capital and operating leases will be replaced by a principles-based approach requiring much more judgment as to which leases are “finance” (currently capital) and which are operating. New disclosures are also required that go well beyond the scope of the current operating lease footnote. Operating leases with terms of less than 12 months can, at a company’s election, be exempted from the new guidance.
How these changes will impact financial statements and performance measurements
Changes in the income statement and statement of cash flows will depend on how companies choose to structure and classify their lease agreements after the effective date of the new standard. Finance leases will be front-loaded with interest expense, while operating lease expense will continue to be recognized on a straight-line basis. Payments of principal on finance leases are considered financing cash flows (the interest portion will be an operating activity), and operating lease payments are still considered operating cash flows. The major impact to the financials is the addition of operating leases to the balance sheet, which will affect performance measurements.
Big increases in liabilities may trigger compliance issues with debt covenants, insurance agreements, and other regulatory requirements. Debt to tangible net worth calculations may be particularly impacted, as, under current U.S. GAAP, right-of-use assets are intangible and not included in tangible net worth. New debt related to right-of-use leases would then have no offsetting asset in such calculations. However, the standard could have a favorable impact on EBITDA calculations if companies structure what may have been operating leases under current guidance as finance leases under the new guidance, due to adding amortization and interest expense and eliminating operating expense from the P&L.
When the new standard takes effect
The new guidance will be effective for fiscal years beginning after December 15, 2018 for public companies and December 15, 2019 for non-public companies. However, companies must apply the standard at the beginning of the earliest period presented in the financials, which will include 2017 for many companies and 2018 for nearly everyone else. Early adoption is also permitted for all companies.
What you can do now
- Take inventory of any current lease agreements that extend past the effective date of the new standard. Determine if new processes or systems may be needed for capturing data.
- Examine your debt covenants and other contractual agreements. Schedule a meeting with your banker, attorney, or other interested parties if you believe that renegotiation of terms may be necessary.
- Develop a lease-vs.-buy model if you don’t already use one. With all leases going on balance sheet, the leverage may be similar whether you rent or buy for some purchases.
- Talk with your tax firm about the potential impacts on your return and how to plan for them.
- Reach out to your 9Gauge team for implementation guidance, budget planning, or more information on how the new standard will impact your business.