The Financial Accounting Standards Board (FASB) released its anticipated update to lease accounting stipulations under accounting principles generally accepted in the United States of America (U.S. GAAP). The updated standard requires businesses to record and recognize the assets and liabilities of all leases with terms longer than 12 months. This mandate applies to both current categories of leases – capital (or finance) and operating.
The primary reason for the update is to standardize reporting practices so that companies present more comparable financial statements. Currently, operating lease obligations are only disclosed in – not recorded on – a company’s financial statements. By contrast, companies omit operating lease obligations from their balance sheets. This omission impacts the analysis of a company’s health, which is performed by investors and rating firms.
The revised standard is expected to bring sweeping changes to how finances appear on balance sheets. In fact, The Wall Street Journal reports that the FASB update could inflate the assets and liabilities of all companies by as much as $2.5 trillion. This increase is just one of the effects that the new requirements may have on businesses with active lease portfolios.
Effects on Lessees
Much of the impact of the new standard falls on lessees (businesses who lease equipment from lessors). They must now be more precise about how they classify and report their lease activity. For instance, regarding capital leases, lessees must now record principal repayments and interest repayments separately on their financial statements.
A potential outcome for some organizations is that their financial ratios may appear weaker with their operating leases included. As a result, lenders may charge higher borrowing costs to mitigate their risks. Thus, companies may decide that they are better off buying instead of renting because either transaction will most likely yield similar leverage (i.e., the use of debt to finance an activity) on their financial statements.
Businesses may also need to invest in internal changes to comply with the new requirements. They may need to create new (or establish supplementary) controls and processes to collect certain newly required lease information. Additionally, they might need to train their employees, as well as users of their financial statements, about the impacts of the new standard.
Effects on Lessors
Lessors that follow current U.S. GAAP should expect few changes to their lease accounting procedures. However, the new mandate includes “targeted improvements” aimed at aligning their practices with lessee accounting standards. For example, lessors may be required to classify some lease payments as liabilities when the collection of these payments is uncertain. Lessors could also see changes in lease negotiations. Current lessees may request lease terms of no longer than 12 months to reduce the impacts on their balance sheets.
CRI Can Help You Start “Tidying Up” Your Lease Accounting Practices Now
The timing for companies to adopt the standard is as follows:
- Public companies will need to implement the new standard in financial periods that begin after December 15, 2018.
- Nonpublic companies that follow GAAP must comply in annual periods that start after December 15, 2019, and in interim periods that begin after December 15, 2020.
Although the mandate does not go into effect for another two to four years, companies that have sizable lease portfolios should begin preparing in advance. It could take some time to not only compile the required information, but to also create new (or modify existing) processes to simplify data collection. If you think the FASB update may apply to your business, then contact CRI’s CPAs and advisors. We can help you polish up on the new standard, guide you through establishing new controls, buff up old processes, and make your financial statements shine.