February 13, 2017

Common questions about the new leasing standard

As part of its ongoing initiative to improve financial reporting, the Financial Accounting Standards Board (FASB) issued a new standard on leasing in February, 2016. The standard has far-reaching effects impacting all businesses that lease any kind of assets, from fax machines to real estate.

In this series, we’ll discuss what the new leasing standard dictates, how businesses should prepare for it and helpful solutions to the challenges they might face along the way.

In our first installment, we’re going to address some of the most frequently asked questions about the new leasing standard.

What are the main differences between the old and new leasing standard? 

Under the current accounting framework, leases are classified as either capital or operating. Capital leases are required to be recognized on a company’s balance sheet while operating leases are not. However, under the new standard, operating leases will also have to be reported on the balance sheet in most circumstances. This new requirement could significantly impact debt covenants because the additional assets and liabilities on the balance sheet could alter a debt covenant ratio, causing the company to no longer be in compliance with that ratio. It’s important that businesses discuss the new standard with their lenders to assess the significance of its impact on their loan covenants.

How will a lease be defined under the new standards?

Lease determination will be dependent on whether the lessee has the right to control the use of the identified asset. If there is no evident control, the arrangement in question may not be a lease. Under the old standard, the focus was a risks and rewards model, rather than a control model. A lessee has the right to control the use of the identified asset if it obtains substantially all of the economic benefits and can direct the use of the identified asset.

When will the new standards take effect?

The standards will take effect for public companies in the fiscal year beginning after Dec. 15, 2018. Private companies will be subject to the new standards in the fiscal year beginning after Dec. 15, 2019. Early adoption is permitted.

Who will be impacted? 

All businesses – regardless of size or sector – will be impacted. The significance of the impact depends on the volume of leasing activity inherent to a business. For example, the retail sector will feel the greatest impact due to its brick and mortar structure. Construction firms will also be substantially impacted as a result of the volume of equipment leased. That said, if your company is leasing anything from soda machines to property, you’re going to be subject to these changes. Stakeholders – primarily investors and creditors – may also be impacted by a business’ changing financials. For example, incorporating operating leases on financial statements will alter common metrics that lenders depend on, such as debt-to-equity ratios.

What should businesses be doing now to prepare?

Businesses should take inventory of company leases and ensure internal controls and processes are in place to eliminate difficulty of adoption. Transitioning leases could be challenging if the company is not compliant with Generally Accepted Accounting Principles (GAAP). We will address how businesses should transition over to the new standard in part two of this series.

Thank you for reading part one of our leasing series. You can find more information about the leasing standard here.

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