The new lease accounting rules will have far-reaching implications for both public and private companies.
The Financial Accounting Standards Board’s leases standard will take effect for public companies for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. For all other organizations, the ASU on leases will take effect for fiscal years beginning after December 15, 2019, and for interim periods within fiscal years beginning after December 15, 2020.
The International Accounting Standards Board’s rule will become effective on January 1, 2019.
The new standards, approved separately, require that leases with a maximum term longer than one year be capitalized on company balance sheets.
With the exception of leases with maximum terms of less than 12 months, no leases will be grandfathered in. That means the impact will be immediate and, in many cases, material to financial statements.
Under the IASB standard, all leases will be classified as finance leases. Under the FASB standard, there will be both operating and finance leases.
Operating leases are recorded on the income statement with straight-line rent expense — similar to today’s operating-lease model, but nonetheless capitalized onto the balance sheet. Finance leases are similar to the current capital lease model. Factors that would trigger a finance classification under the FASB rules include the following:
- The lessor transfers ownership of the underlying asset to the lessee by the end of the lease term.
- The lease grants the lessee an option to purchase the underlying asset, and the lessee is likely to exercise that option.
- The present value of the sum of the lease payments and any lessee residual value guarantee not reflected in the lease payments is equal to or exceeds “substantially all” of the underlying asset’s fair value.
- The underlying asset is expected to have no alternative use to the lessor at the end of the lease term.
These classifications will have a real impact on financial statements, influencing everything from cash-flow presentation and balance-sheet metrics to net income and EBITDA. Below are examples that demonstrate how the new rules will affect financial statements.
- A finance lease will be categorized as a financing activity on the statement of cash flows.
- The liability for a finance lease will be classified as debt, which will have a detrimental impact on a company’s debt-to-equity ratio and threaten loan covenants.
- Shareholder equity will take more of a hit from a finance classification versus an operating classification.
- Expense reported on the income statement for finance leases will include a combination of amortization of the “right of use asset” and front-loaded interest expense assessed against the outstanding lease liability.
These impacts translate into big changes to balance-sheet metrics like debt-to-equity ratios and will also have a significant impact on net income and EBITDA. This is especially true for finance leases.
Operating leases, in contrast, result in straight-line rent expense being reflected on the income statement, which is how most companies record leases today.
Late Changes to the Rules
Before the rules were finalized, FASB and IASB made a few last-minute changes.
For one, a gross lease will now trigger the inclusion of taxes and insurance on the balance sheet. Because of this, companies that are focused on EBITDA may find gross leases classified as finance leases to be more advantageous. That’s because finance leases allow taxes and insurance to flow through the income statement as interest and amortization, instead of selling, general, and administrative (SG&A) expenses.
In contrast, companies concerned about the balance-sheet implication of a lease classification will prefer operating leases, because shareholder equity is less impacted.
Other late changes to the rules relate to subleases. When FASB and IASB were close to finalizing the rules, they were reminded that existing subleases — at least those where the sublessor recognized a loss on the sublease — were already impacting the balance sheet of the sublessor. As a result, bringing the underlying lease onto the balance sheet would effectively result in two liabilities for the same obligation.
FASB and IASB revised the proposed standards late in the process to account for new and existing subleases. The result of that change is that leases that have previously been subleased will reappear on the balance sheet and income statement of the sublessor.
The new sublease accounting rules look nothing like current sublease accounting rules, which were already fairly complex, causing even more challenges in adopting the new standards.
Many Companies Unprepared
The new lease accounting rules were debated publicly and within FASB and IASB for more than six years, and the lengthy process lulled mny companies into a false sense of security.
Many CFOs took an “I’ll believe it when I see it” approach to the standards, which was understandable after the rules seemed stuck in limbo for years. Then, when the rules were finally approved, companies were in the throes of dealing with the new revenue-recognition standards slated to take effect in 2018. So, for many companies, preparing for the new lease accounting changes has not been a top priority.
Yet the deadline of January 2019 remains set. Public companies that have yet to turn their attention toward this issue should consider that they will have comparative reporting in their 2019 financial statements that will reflect 2017 and 2018, and the window is quickly closing for them to invest the time and resources required to understand and mitigate the rules’ impact.
Also, companies subject to SEC reporting requirements would be wise to remember the commission requires them to disclose the impact of new accounting standards that have been issued, but not yet adopted, in advance of those rules going into effect.
One of the biggest obstacles to readiness is the availability of information about existing leases. Many components of rent payments are not tracked under existing accounting standards. Operating costs are often included in rent payments, but under the new ones they will need to be segregated from gross rental costs for purposes of calculating the asset and liability associated with any lease.
Also, under the new rules, property tax and insurance costs in a gross lease — which may be part of an aggregate “operating expense” value — will be required to be capitalized. Failing to bifurcate service components from “rent,” or entering into gross leases as opposed to net leases, will result in the balance sheet being materially and unnecessarily overstated.
Adding complexity to the already-time-consuming process of reviewing lease structures, many companies with legacy lease administration software are finding they cannot use these applications to run lease accounting analysis under the new standards.
Consequently, in order to move forward firms are either re-abstracting lease data or finding ways to blend that data with other reporting data. For many CFOs, this has become a major compliance obstacle.
The rules are both a scourge and a potential blessing. On the one hand, CFOs will have to invest considerable time and resources into complying with the new standards. On the other hand, they will have a chance to better understand how lease obligations truly impact the bottom line.
There is a tremendous strategic opportunity for companies to improve financial performance if they scrutinize their leases — especially those that are currently being negotiated or will be soon.
The longer companies wait to get started, the more difficult compliance becomes. Wishful thinkers may be hoping that FASB and IASB will delay the compliance deadline, but there is no indication that will happen.
Strategic planners, in contrast, are looking for ways to adjust their leases and use the information they are generating to improve performance. Those that choose the latter approach are more likely to be prepared and position their companies to thrive under the new rules.
Sean Moynihan is a principal in the office properties group at Avison Young, a commercial real estate services firm based in Atlanta. He can be reached at email@example.com.