By Mike Bedel, CPA, MBA, CGMA
Partner, Director of Audit & Assurance Services
[email protected]
Balance sheets are changing! A new update released by the Financial Accounting Standards Board (FASB) in February of this year spells out the changes resulting from a lengthy deliberation on the treatment of leases in U.S. Generally Accepted Accounting Principles (GAAP).
The main changes will be noticeable to lessees involved in an operating lease – which is probably the most common lease arrangement we see in privately held organizations. Previously these leases were disclosed in the footnotes of the financial statements. After the changes go into effect, these leases will be recognized on the balance sheets of lessees as lease assets and lease liabilities.
The recognized lease asset represents a right to use the underlying leased asset over the term of the lease, and the recognized liability represents the obligation to make lease payments under the related lease agreement. In situations where an extension of the lease agreement terms is anticipated, the extended terms will be used to recognize the related asset and liability.
For example, if you lease a vehicle under an operating lease, the new standards will require you to recognize the value of your right to use that vehicle as an asset and the present value of the lease payments as a liability.
The good news, for now, is that these changes will not take effect until 2020 for most privately held organizations (years beginning after December 15, 2019). This provides time to prepare.
One of the main areas of concern voiced by initial readers of the new standards is that this recognition of assets and liabilities will impact financial ratios often used to manage debt covenants. By recognizing assets and liabilities that were not on the balance sheet before, the equity section of the balance sheet seems to shrink proportionally.
Now is a good time to investigate and start discussions with your trusted advisors about the impact this standard could have on any debt covenants you have with a bank or other financing institution.
The tracking of operating leases has traditionally been fairly simple. Monthly payments were made and recorded to expense. With the new standards, however, the asset will need to be adjusted with each payment and maintained more similarly to a property and equipment schedule.
Similarly, the liability arising from the operating lease payments will need to be tracked and reduced over time. For an organization with one or two leases, this will still be relatively easy. However, if your business model relies on a larger quantity of leases, this may require the purchase of additional software to track the lease assets and liabilities.
Many organizations will also want to take this opportunity to reevaluate the completeness of their list of operating leases. Where a missed lease in the past was difficult to identify, the missing asset and liability may be more impactful on the updated balance sheet under the new rules.
Finally, organizations will need to make a determination about when to implement the new lease standards. The FASB will allow early adoption of the leasing standards, but full compliance is required by 2020.
We will be sharing more technical implementation ideas about the changes in lease standards in the future. If you have any questions, please contact Mike Bedel at (317) 613-7852 or email [email protected].