On Thursday (February 25, 2016), the FASB issued the long-awaited new standards for leases. According to a Journal of Accountancy article published yesterday:
“FASB’s Accounting Standards Update No. 2016-02 will require lessees to report obligations for operating leases on the balance sheet for the first time.”
If you are a business owner today, in most cases you have dealt with two general types of leases in the past: Operating Leases and Capital Leases.
- An operating lease in the past was generally recorded as an expense on a straight-line basis over the term of the lease (e.g. if you pay $500 per month for 3 years, that is your lease expense per month… or if there are guaranteed increases in the amount per month you usually record the average monthly payment as your monthly lease expense).
- A capital lease is a lease that was treated almost the same as long-term debt when the terms of the lease that were more closely akin to a long-term debt arrangement.
According to the Financial Accounting Standards Board (FASB), they issued this new update to the lease accounting standards to “increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements.” Part of the background in the FASB’s desire to issue new standards was that the old method for reporting operating leases was frequently criticized for “failing to meet the needs of users of the financial statements…” One of the specific criticisms is that “it did not require lessees to recognize assets and liabilities arising from operating leases on the balance sheet.”
Here is a simple example. Let’s say that your company leases an automobile for company use for two years and the monthly payment is $500 per month. Using the old lease accounting rules, there would generally be no asset or liability on the balance sheet and for income statement purposes there would only be a month charge of $500 to rent expense. However under the new FASB rules, you would record an asset on the balance sheet intended to represent the value of that right-of-use asset…and you would record a liability. Initially this value for both the asset and the liability would equal the present value of the lease payments. However if for some reason the value of the right-of-use asset changes, then there could be potential adjustments to the asset recorded on the balance sheet in future periods.
Unfortunately, as the lease gets more complex, there are many other detail considerations beyond what you see in the simple example above.
So when will this affect your business? For most private businesses this will become effective for financial statements issued for fiscal years beginning after December 15, 2019. A publicly held business or certain non-profits will be required to implement these new rules a year earlier than this. The good news is you have some time to assess the financial statement impact on your business, debt covenants, etc. It is most likely that banks will need to modify future lending covenants to incorporate the affect that these new standards will have on their clients’ debt ratios and other related KPIs.
If you want more information on how these new lease rules may impact your business, please contact a B2B CFO® partner in your area.