New Lease Accounting Standard Comes into Effect Soon

In just a few months, a new lease accounting standard will come into effect that will result in changes to the way that companies are required to record leases on their books. The new standard will primarily affect lessees and is mainly intended to provide more transparency for financial statement readers, allow financial statements to be more comparable, and bring the standard more in line with IFRS 16.

Publicly traded companies must follow the new standard if their fiscal year begins after December 15, 2018. As an example, if a company’s fiscal year is in line with the calendar year, then it must follow this standard as of January 1, 2019. All other companies will have an extra year to get in line (lucky for you!).

So, let’s first speak about the current lease requirements then discuss how the accounting will change when the new standard goes into effect.

What the Standard Requires Now

A lease can either be classified as an operating lease or a capital lease. Currently, operating leases are off-balance sheet transactions and are, therefore, reflected as expenses on the income statement. On the other hand, capital leases are carried on the balance sheet. There are four rules that must be considered to determine which category a lease falls under and, thus, how it is accounted for. The rules are as follows:

1. The lease term is 75% of the asset’s useful life; or

2. Present value of minimum lease payments amount to 90% of fair value of asset at beginning of lease; or

3. Transfer of ownership from the lessor to lessee at end of the lease period; or

4. Bargain purchase option for lessee to purchase asset at end of lease for a price below market value.

Note that this is an “either or” situation meaning that not all these rules must be met to be considered a capital lease; just one.

You should be able to appreciate that, currently, if a capital lease is incorrectly classified as an operating lease then this will understate the company’s profits (due to the corresponding expense). On the other hand, classifying an operating lease as a capital lease would overstate assets and liabilities. In either case, this is a violation of accounting standards (GAAP) and, depending on the materiality and/or intent, could lead to a qualified or adverse audit report.

How Will Lease Accounting Change When Implemented?

Now we get to the juicy part. How will the new standard affect the accounting of leases in the future?

Well, the rationale behind this change is that all leases, regardless of type, will result in an asset and a liability, so why not record them as such? Hence, the biggest change is that if the lease is valid for more than 12 months, then both capital and operating leases will be reported as an asset (with corresponding liability) on the balance sheet, although the recognition, presentation and measurement will differ. This means that if the lease term is less than 12 months, then the company can elect to record the operating lease in the income statement.

Due to the value of leased assets, this is considered a major change in standard and will, of course, have a significant impact on companies.

Another change is that lessees will be required to provide additional disclosures related to their ability to make lease payments, the payment amounts, and timing. This is good for financial statement users and investors because they get a better appreciation of the numbers reported.

The bottom line is this; companies will need to anticipate these changes and revamp their accounting to be compliant when the time comes. If you need more details on the new standard, check out this update from the FASB.

Oh, by the way, you’re allowed to early adopt. So, get to it!