Lease accounting has never been most people’s favorite accounting topic, but the Financial Accounting Standards Board (FASB) has recently upped the complexity with a new wrinkle to the existing treatment of leases. While this new guidance is not applicable for a few more years, it is good to understand the implications it may have on your business now.
Currently, leases are divided up into two categories, operating and capital. To qualify as a capital lease lease, you must meet one of four criteria; 1) ownership transfers at the end of the lease term, 2) there is a bargain purchase option at the end of the lease term, 3) the term of the lease is 75% or more of the estimated useful life of the asset or 4) the present value of the lease payments is 90% or more of the original cost of the asset. The assets under these leases are capitalized and offset by a liability for the principal payments to be made over the life of the lease. The asset is depreciated as any capitalized asset would be. When payments are made, there is a principal and interest portion, similar to any financing debt.
By default, if none of the capital lease qualifications are met, you have an operating lease. There is currently no asset or liability associated with operating leases and any payments are treated as lease expense on your income statement.
In 2016, the FASB issued Accounting Standards Update 2016-02, which changes the accounting for operating leases. Starting in 2019 for public companies and 2020 for non-public, there will now be an asset and a liability on the balance sheet related to any operating leases with a duration in excess of 12 months, including extensions that are likely to be renewed. The thinking behind this is that if a business is committed to making payments over a long term period of time, there should be a liability representing this obligation on their balance sheet. There is now also a corresponding asset that represents the business’ right to use the asset.
Mechanically, there should be no change to the income statement. The asset and liability are amortized in tandem over the life of the lease and any lease payments still are reflected as lease expense on the income statement. Where there is the potential for impact to a business is in their bank covenants. Any ratios that involve debt, such as debt to equity, will have an increase in the debt side with no corresponding adjustment on the equity side. Even an asset to liability ratio will be affected, as the impact on the numerator and denominator will differ. The ratio that will probably see the greatest impact is the current ratio. The new asset will be classified as non-current while the portion of the new liability to be amortized over the next 12 months will be considered current.
If you have any ratios that may be impacted by current leasing arrangements or if you intend to enter into new leasing arrangements, now is the time to start talking to your lending institution about how your covenants might be affected.