Many private companies are still unaware of the balance sheet effects of new lease accounting rules, including lease capitalization requirements, that go into effect starting in 2020. Here’s what to expect and how private companies can adapt.
Under the existing accounting rules, a lease obligation is reported on the balance sheet of the company that leases the asset (the lessee) only if the arrangement is similar to a financing arrangement — then it’s considered a capital (or finance) lease. Otherwise, it’s an operating lease, which is expensed as lease payments are incurred, with the terms disclosed in the footnotes.
For example, if you lease a computer for most of its useful life and can purchase it for $1 at the end of the lease term, the arrangement would likely qualify as a capital lease. But if you sign a five-year lease on office space, it would probably be classified as an operating lease under current practice.
The Financial Accounting Standards Board (FASB) estimates that this treatment has allowed companies to keep roughly 85% of their leases off their balance sheets. But that’s changing under Accounting Standards Update (ASU) No. 2016-02, Leases (Topic 842). For public companies, the new standard is effective for fiscal years beginning after December 14, 2018 (in other words, in 2019 for calendar-year public companies).
Although private companies have an additional year to implement the changes, they shouldn’t wait until the last minute to change their accounting practices and systems. Tracking leased assets and evaluating their contractual terms can be a time-consuming endeavor.
Preparing for the changes
The updated accounting rules for leases can require big systems changes for companies, depending on the number of leases a company carries, because software programs must be tailored. Despite education outreach efforts by the FASB, recent surveys indicate that many private company executives feel unprepared to comply with their 2020 lease accounting compliance deadline.
At this time last year, public company executives reported fewer concerns about the 2019 deadline they faced. But public companies that have already implemented the new lease standard report that the process took much more legwork than they’d anticipated.
The big difference between the existing rules and the new ones is that all leases with terms of more than 12 months will be reported on the balance sheet. Initially, the liability will be based on the net present value of those payments and the value of the right-to-use assets. Companies can also elect to capitalize leases with terms of 12 months or less.
In addition, lessees will need to expand disclosures about the terms and assumptions used to estimate their lease obligations, including information about variable lease payments, options to renew and terminate leases, and options to purchase leased assets. As a practical expedient, the new standard allows private companies and not-for-profit organizations to use risk-free rates to measure lease liabilities. But, beware: Some contracts that qualify as leases won’t have the word “lease” written across the top of them. Instead, a lease may be embedded in the fine print of a service contract.
Private companies that follow U.S. Generally Accepted Accounting Principles (GAAP) and lease real estate, equipment and other assets will probably notice major changes to their balance sheets and footnote disclosures, starting in 2020. Don’t underestimate the amount of time and effort that’s needed to implement the changes to the lease accounting rules. DLA can help you identify lease contracts and alleviate any implementation headaches.
Time of change
A glut of broad new accounting changes has overwhelmed the finance and accounting departments of many businesses. Here’s a quick overview of what’s changing when.
Revenue recognition. Starting in 2018 for public companies and 2019 for private ones, revenue must be reported using new principles-based guidance under Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers.
Credit losses. Starting in 2020 for public companies and in 2021 for private ones, ASU No. 2016-13, Financial Instruments — Credit Losses: Measurement of Credit Losses on Financial Instruments, requires banks and other companies that extend credit to immediately record the full amount of expected credit losses in their loan portfolios.
Tax Cuts and Jobs Act. In late 2017, Congress made sweeping changes to the federal tax code. Most of the changes for businesses are permanent and go into effect for tax years starting after December 31, 2017. As the law’s name suggests, many of its provisions cut taxes by lowering federal tax rates and expanding allowable deductions for businesses. But some changes are unfavorable to businesses. To complicate matters, many states have decided to decouple their state income tax rules from the TCJA changes. Differences in tax rules across state lines add complexity to filing business tax returns.
Given the scope of change that’s happening in the business world, it’s no wonder that your finance and accounting personnel feel overwhelmed. To ease frustration, DLA can help you understand how these changes will affect your business in the coming years.