By Erin Silkowski
Your company’s operation might rely heavily on leasing equipment or property as a way of using assets without the burden of purchasing or disposing of them when no longer needed. Due to changes adopted by the Financial Accounting Standards Board, many of these lease agreements that take place off the balance sheets will soon find their way on to them. As a result, it is essential to familiarize yourself with the upcoming changes sooner rather than later to avoid surprises when reports are due.
To put timing into perspective, this update is effective for public companies, certain not-for-profits and benefit plans for interim and annual reporting periods beginning after Dec. 15, 2018. Private companies will have to adopt the new standards beginning after Dec. 15, 2019, although early adoption is permitted.
Here are the key elements of the coming changes.
1. Contractual arrangements must be reviewed to determine whether they contain a “lease.” By definition, a lease conveys the right to control the use of an identified asset for a period of time in exchange for consideration, thereby creating an asset and a liability for lessees that must be reflected on the balance sheet. A supplier cannot have the right to substitute the asset used to fulfill the contract. In addition, the lessee must have the right to obtain all of the economic benefits from the use of the asset and the right to direct the use of the asset. These parameters create a distinction between a lease and a service contract.
2. The length of the lease. The new guidelines will only apply to leases longer than one year.
3. New classifications for leases will be established. Under the old guidance, there were two classifications –- operating leases and capital leases. Under the new guidance, “capital leases” are replaced with “financing leases,” which carry a more subjective definition than the old standards. Only one of the following five criteria must be met for a lease to be considered a financing lease.
- The lease grants the lessee an option to purchase the asset that the lessee is reasonably certain to exercise. This differs from the previous “bargain purchase” option.
- The lease transfers ownership of the asset to the lessee by the end of the lease term.
- The lease term is for the major part of the remaining economic life of the underlying asset. The previous standard used the 75 percent rule.
- The present value of the sum of lease payments and any residual value guaranteed by the lessee that is not already reflected in lease payments equals or exceeds substantially all of the fair value of the underlying asset. The previous rule was 90 percent of the fair value.
- The asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.
4. Financial statements will be affected. These changes have a broad reach; therefore, they are going to result in almost all leases being recorded on the balance sheet, along with a related liability. This will affect financial covenants with banks (such as the debt service coverage ratio) and financial metrics (debt to equity ratio and working capital) and financial statement disclosures. If you have financial covenants with banks, schedule a meeting with your CPA to discuss the potential changes to your assets and liabilities and financial ratios. Although the coming changes do not take effect until the end of 2018, and for others, the end of 2019, now is the time to prepare for these changes so that you are ready to apply them when they become effective.
Erin Silkowski is an Audit Senior at Wiss & Company. If you would like to speak with Erin about this topic, you may reach her at email@example.com or at 973.994.9400.