Just over two years ago, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update 2016-02—Leases (the “ASU” or “Topic 842”), which is intended to increase the financial reporting transparency and comparability of lease accounting. This new accounting standard, which replaces existing accounting guidance currently applied in practice, will be effective as soon as January 1, 2019 for public business entities (including certain not-for-profits and employee benefit plans) that have calendar year-ends. All other entities will have one additional year to implement. 

Whether public or private, it is in the best interest of all reporting entities with leases to begin their implementation now. Reporting entities leasing assets like real estate or equipment (e.g. hardware such as computer servers, or equipment used in construction, manufacturing or transportation) must understand and apply this new accounting standard requiring lessees to recognize assets and liabilities for most, if not all, of their leases. While lessees will feel the greatest impact from the new standard, lessors should recognize that they must also consider the extent to which Topic 842 will affect their lease accounting.

Under existing lessee accounting guidance, capital leases—referred to as “finance leases” in the new accounting standard—result in the recognition of assets and liabilities. On the other hand, the accounting for operating leases generally has little or no balance sheet impact. Under the new accounting standard, lease assets and liabilities must be recognized for both operating and finance leases in lessee balance sheets, with additional disclosure in the accompanying notes.

The most significant change in the ASU is the requirement that lessees recognize lease liabilities on their balance sheets for all leases excluding short-term leases that meet specific criteria. Lessees, including those that lease equipment, vehicles and aircraft, will lose the benefit of the off-balance sheet accounting under the existing accounting guidance that Topic 842 is replacing.

Positioning for the change

The time to implement the new lease accounting standard has arrived. The ASU will take effect for public business entities (including certain not-for-profits and employee benefit plans) for fiscal years beginning after December 15, 2018 and interim periods within those fiscal years. For all other entities, the new accounting standard will apply to fiscal years beginning after December 15, 2019, and interim periods within fiscal years beginning after December 15, 2020. 

The FASB recommends that reporting entities create a transition timeline and action plan for implementation of the new standard immediately. The thrust of the change affecting financial statement preparation will involve recognizing balance sheet liabilities for operating lease obligations. It is imperative that reporting entities not underestimate the amount of effort that will be required to implement and comply with the new lease accounting standard – dependent on the volume of a reporting entity’s leasing activity and the complexity of its lease agreements. 

One of the more significant potential impacts may be the detrimental effect the new standard could have on measures of leverage and common financial covenants, such as debt-to-equity ratios. Depending on how covenants are structured, a lessee may find that it is no longer in compliance with financial covenants purely due to the recognition of lease liabilities for new and existing lease agreements. It is unclear how and whether lenders’ willingness to extend credit will be affected by the new standard. In addition, the new accounting standard could impact economic decisions such as whether to lease or buy property, plant and equipment. 

Conduct a pre-implementation analysis

To avoid complications that may arise from the adoption of the new accounting standard, business owners and C-suite management should assess the potential financial effects well ahead of implementation. Early analysis will allow reporting entities the time needed to discuss the projected impact with their financial partners and lenders, helping to avoid problems when the new standard becomes effective.

This analysis should be comprehensive and must consider elements such as lease term, options (e.g. renewals and purchase options), lease components embedded within contractual arrangements, non-lease components, and related-party transactions. Companies should include other departments, such as treasury, legal, IT, and operations in their analysis process.

Organizations will benefit from proactively thinking through the implications of implementing this new accounting standard.