After more than a decade of work, the Financial Accounting Standards Board (“FASB”) has just issued an update to its standards that will require companies to record substantially all lease assets and liabilities on company balance sheets, potentially significantly affecting the amounts investors are used to seeing in financial statements.
The changes — similar to guidelines announced by the International Accounting Standards Board about a month ago — could transfer “north of a trillion” dollars in economic activity from the footnotes of financial statements to the balance sheet according to remarks made by FASB Vice Chairman James Kroeker.
Although the changes don’t start taking effect for about three years, they will require a good deal of effort to comply and companies should start preparing now. (See some tips for getting ready below.)
Most of the changes, contained in FASB Accounting Standards Update No. 2016-02 will affect lessees, requiring them to recognize both capital (finance) and operating leases on the balance sheet. Previously, GAAP required that companies only recognize assets and the related liability for capital leases, which was based upon a four-step test. How lessees record the associated cash flows and expenses resulting from leases will depend upon this dual classification system.
Under the new guidelines, lessees will recognize amortization of the right-of-use asset for capital (finance) leases separately from interest expense on the lease liability. Operating leases now require a right-of-use asset to be recorded by lessees, with a single total lease expense recorded on a straight-line basis over the lease term.
The new FASB standards for lessors will remain similar to what it is under current GAAP.
For leases with terms longer than 12 months, the standard will take effect for public companies for fiscal years, and interim periods within those fiscal years, beginning after Dec. 15, 2018. For all other organizations, the new standard on leases will take effect for fiscal years beginning after Dec. 15, 2019, and for interim periods within fiscal years beginning after Dec. 15, 2020. Early application will be permitted for all organizations. Short-term leases (those with terms less than 12 months) are exempt from this standard.
The impetus for updating the standards stems from a 2005 request by the Securities and Exchange Commission to help improve transparency on corporate balance sheets. In response, FASB and the International Accounting Standards Board began to work together on developing the update. While they ultimately agreed on most points, the IASB did not adopt the dual classification model.
Speaking to the Journal of Accountancy, Kroeker offers five key suggestions to prepare for the changes:
- Start right away. Companies should begin assembling broad teams — including finance, accounting, and legal personnel–to work on implementation.
- Review legal agreements and debt covenants. This is particularly important for private companies since changes to a balance sheet may affect contractual agreements or loan covenants.
- Think carefully before purchasing a new software system. Kroeker said FASB developed the new standard in a way that would allow organizations to incorporate the changes using their current accounting and reporting systems.
- Evaluate leasing processes. With the accounting changes, companies may want to consider how they handle leases internally. For example, Kroeker said, organizations may want to consider centralizing their lease process for improved efficiency or cost-effectiveness in implementation.
- Reach out for help. To avoid any unintended consequences or other struggles, Kroeker said preparers should contact FASB with questions.
The best recommendation for companies to begin implementing now is to begin compiling an inventory of all leases currently maintained. This includes identifying all contracts containing a lease, filing the contracts in a common location on your company’s network, and aggregating relevant information from each contract. The key information is the vendor, date the lease commenced, lease term, underlying assets (and associated asset value at the date of the lease), and required lease payments (noting any lease payment escalation provisions).
Once this step is performed, a company can then develop an estimate of the potential balance sheet impact they will experience upon adoption. Although certain of these leases may expire before the new lease standard becomes effective, implementing a process to maintain and monitor leases now will ease the transition when this standard is required to be adopted.
Brad Bonde is a Senior Manager with LBMC’s Healthcare Services Assurance team. He primarily specializes in private equity and venture capital-backed healthcare entities.
Jim Callihan is a Partner in the LBMC Audit and Advisory practice. He has served clients in a variety of sectors, including consumer and industrial products, services, and electric and gas utilities.