With the issuance of ASU 2016-02, Leases, the Financial Accounting Standards Board (FASB) made changes to accounting standards for leases that will have a significant impact on many companies’ balance sheets including construction and real estate industry businesses. Companies that lease real and personal property will see both their assets and liabilities increase, potentially impacting financial ratios, which lenders or sureties may use when evaluating the company.
Prior to the effective date of ASU 2016-02, leases were recorded one of two ways:
- Capital or finance leases, which were recorded on the balance sheet as though the company had purchased the leased asset and financed the acquisition; or
- Operating leases, for which lease payments were recorded as expenses in the period incurred and no related asset or liability were recognized.
Under the new guidance, lessees will be capitalizing substantially all lease agreements on their balance sheets as a right-of-use asset, along with a related lease liability. The lessee can elect an accounting policy to not record short term leases on the balance sheet. Short term leases are defined as leases with a term at commencement of 12 months or less which do not include a purchase option that is reasonably certain to be exercised. The election allows for straight-line expensing of lease payments over the lease term, with no related asset or liability recorded.
All other leases are classified as either finance leases or operating leases. Finance leases, where the lease transfers the control of the underlying asset to the lessee, recognize amortization expense over the term of the lease, along with interest expense, as payments are made against the lease liability. For, operating leases, where the lessee obtains control of only the use of the underlying asset, expense is recognized on a straight-line basis over the life of the lease.
While the changes under the standards are primarily targeted at lessee accounting, lessor accounting was updated to align to the new lessee rules and the FASB’s new revenue recognition standards. For lessors, leases are classified as either a sales-type, direct financing or an operating lease. Unlike lessees, who are required to record a lease liability and right of use asset for all leases, the type of lease determines what lessors must report on their financial statements. Lessors report lease receivables for sales-type and direct financing leases with interest income that is typically front loaded, higher at the beginning of the term, declining over the term. In a sales-type lease, the lessee obtains control of the underlying asset and the lessor recognizes the sales revenue and profit at the inception of the lease. In direct financing leases, where the sum of the lease payments and any residual guarantee equal substantially all the fair market value of the underlying asset, the profit is recognized over the lease term. Operating leases recognize the lease income on a straight-line basis and the underlying assets remains on the lessor’s balance sheet and is depreciated.
Financial Statement Disclosures
The objective of the financial statement disclosures under the new standard is to enable the users to understand the amount, timing and uncertainty of cash flows arising from the leases. Lessors and lessees are required to include both quantitative and qualitative information about the leasing arrangements. Such disclosures include the nature of leasing arrangements, the judgements made in applying the lease standards and the amounts recognized in the financial statements related to the leases. An appropriate amount of detail is required so the information provided is meaningful to the financial statement users.
Related Party Leases
It is a common arrangement for closely held companies to operate out of facilities owned through a related party entity or to lease equipment from such an entity. Often, the written terms of lease agreements (if there is a written agreement) are on a month-to-month basis or for a relatively short term. Under the standard, the stated lease term in such arrangements may need to be ignored if other factors give clear indication that the lease term may effectively be longer than the stated term.
Effective Date and Transition Guidance
ASU 2016-02 is effective for non-public companies for fiscal years beginning after December 15, 2019 and interim periods with fiscal years beginning after December 15, 2020. The standard permits two approaches to implementation:
- Modified retrospective, in which companies apply the new rules to leases in existence at the beginning of the earliest period presented in the financial statements. For non-public companies with a calendar year end, this means that information to determine the impact of the new standard for calendar 2019 will need to be gathered, so that it can be applied when comparative 2019-2020 statements are issued.
- Retrospective, wherein companies apply the new rules at the beginning of the period of adoption through a cumulative effect adjustment to equity. Prior comparative periods will not be adjusted under this method.
FASB also included several optional, practical expedients to help ease the transition. One such expedient allows the company to use hindsight in determining the term of a lease and in assessing impairment of any right-of-use assets. The other expedient consists of three parts, which must be elected as a group, allowing the company to not reassess (1) whether any expired or existing contracts contain leases, (2) lease classification for any expired or existing leases, and (3) initial indirect costs for any existing leases.
Preparing for the Transition
As the implementation date of ASU 2016-02 approaches, there are steps companies should begin taking to prepare:
- Review your existing leases and determine the potential impact the new standard will have on your financial reporting. Lessees with a large volume of operating leases will likely see the most dramatic impact, as these leases will be reported ono the balance sheet for the first time.
- Consider the impact of the new standard on new lease agreements being negotiated.
- If you determine that the new standard is likely to affect key financial ratios that lenders or sureties use, be proactive in discussing these effects with them. Although the economics of the underlying lease arrangements haven’t changed, the impact on the figures on your financial statements may be significant. For instance, lessee’s debt-to-equity ratios may increase, even though no new obligations exist. If necessary, discuss potential modifications to loan agreements with your lender, such as modifying the definition of debt or adjusting the required ratio.
- If the changes will affect key performance indicators used to calculate performance-based compensation, consider changes to the calculations of such compensation to mitigate the effects.
With the potential for significant impact on your business, construction and real estate companies, or other organizations affected by the implementation of ASU 2016-02, should reach out to their Sikich advisor for assistance with this transition.
About the Author
JASON KOEBBE, CPA
Manager, Certified Public Accountants & Advisors