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July 31, 2017

Repercussions of the New Leasing Standard (article)

Accounting Standards Update 2016-02, Leases (ASC Topic 842), affects all leases (e.g., property, equipment, copiers) with only a few minor scope exceptions. The new guidance begins to take effect in the 2019 calendar year. Although public companies will adopt first, all entities need to be proactive in evaluating the impact of the standard. The accounting changes may affect debt covenant compliance, evaluation of leasing alternatives, responsibilities of accounting and finance departments, and lease negotiations.

Summary of Major Changes

Lessees will classify a lease as either operating or financing, and nearly all leases will be presented on the balance sheet. The evaluation of operating versus finance leases will be similar to current practice with a new criterion to consider assets of a specialized nature. Bright lines established in current guidance have been removed.

Impact on Rental Leases

The type of lease will impact how you report rental expense on your income statement. For most operating leases, a lessee will recognize rental expense on a straight-line basis over the lease term. For finance leases, a lessee will recognize rental expense under the effective interest method.

In regards to lease term, any renewal options that are reasonably certain to be exercised should be included in the lease term. The conclusion requires reassessment upon triggering events.

Effect on Debt Covenants

Operating and finance leases are recognized on the balance sheet through right-of-use (ROU) assets and related lease obligations. Classifying leases as liabilities may affect metrics for your debt covenant compliance, and while banks are likely already using a factor to adjust operating lease payments in situations where these payments are a significant expense, you should discuss lease liability classification with your bank.

Impact on Types of Leases

Changes to lease accounting may trigger more synthetic lease structures or structures where a special purpose entity is created and “owns” the leased asset and leases the assets to an operating entity. However, given their highly specialized nature, it is likely that synthetic leases will primarily be seen in sophisticated investment markets.

A demand is also expected for other types of alternative lease structures because of the effect of the standard on financial statements. For example, short-term leases may be more appealing because a lessee is permitted to forgo recognizing an ROU asset and related lease liability on its balance sheet. Other companies may consider buying assets or funding tenant improvements instead of including them in leases if cost of capital is less than the interest rate implicit in the lease.

Additional Responsibilities for Accounting & Finance Departments

Previously, if leases embedded in contracts were missed, the impact would be misclassification of operating expenses (e.g., cost of goods sold (COGS) vs. rent). However, because leases are now presented on the balance sheet, there is a much greater risk of misidentifying embedded leases.

Identifying the appropriate unit of account by which to measure the lease and distinguishing between lease and non-lease components will also require involvement from the accounting and finance functions.

Finally, impairment models will need to address the new lease related assets. Consideration must be given to how cash flows are calculated and compared to the asset base.

More Time Needed for Lease Negotiations

More time will be needed for leasing decisions, and given the potential effect on your financial statements alternatives to leasing may need to be explored. For upcoming renewals or new deals, be sure your projections and those of your bank include the accounting standard’s effect on debt covenant compliance.

In the interim, consider whether you need to modify your internal controls to help ensure compliance with the new requirements and have the appropriate, audit-ready documentation to comply with the standard. You should also evaluate whether the relevant system solutions you are using are capable of accounting for your leases with the new guidance.

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