Here’s What Happened
On February 25, 2016 the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2016-02, Leases (Topic 842). An SEC finding in 2005 led to a joint effort between FASB and the International Accounting Standards Board (IASB) that has resulted in a change to how operating leases will be treated in the future. ASU No. 2016-02 eliminates the off-balance sheet treatment of operating leases, and operating lease-related assets and liabilities will now be recorded on the balance sheet. This is bound to have an influence on the way many companies treat leases in the long-run, with increased significance on length of lease terms and contract variables included within the lease agreement.
Operating Leases Find a New Home
Prior to ASU No. 2016-02, capital leases were recognized on the balance sheet, and operating leases were disclosed in the footnotes to the financial statements. The balance sheet recognition of operating leases will be paired with new disclosure requirements in an effort to better explain cash flows from leasing activities. This change was made in an effort to increase transparency in regards to the way a company decides to finance assets used in their business. FASB intends for improved representation of a company’s leasing transactions as a result of ASU No. 2016-02. Needless to say, this could prove to have a great impact on some companies.
Now that the FASB rule change has been put in play, how long do we have? For public companies, not-for-profit organizations, and employee benefits plans with SEC reporting requirements, ASU No. 2016-02 requires that for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years, affected companies must recognize assets and liabilities for operating leases with terms longer than 12 months. For all other organizations, this change will take effect for fiscal years and interim periods beginning after December 15, 2019, and interim periods within fiscal years beginning after December 15, 2020. This includes both new and existing operating leases for all companies.
Classification of Leases and Understanding Lease Components
FASB expects leases that qualify as a capital lease or an operating lease under current accounting standards to remain so under the new ASU. Determining what constitutes a capital lease versus an operating lease has remained significantly unchanged. However, companies will need to fully understand leasing and non-leasing components of their various obligations so as to properly state operating leases on the balance sheet. Typical operating leases for many companies include but are not limited to:
- Machinery and equipment leases
- Land leases
- Other depreciable asset leases
- Leased office space
What This Means for Your Company
Many companies expect to allocate additional resources or to incur additional expenses due to this FASB rule change. If you’re wondering whether your company will be affected, the answer is yes in many cases. The actual financial impact on your company may not be apparent yet. If you plan to seek financing for your company in the near future, this ASU may ultimately affect your lender’s decision. The balance sheet impact could have a negative impact on financial ratios and key performance indicators (KPI) that your lender looks at to determine your company’s financial health and viability. There may be tax ramifications as well.
This article serves as an introduction for some, and a reminder for others. Many companies are looking into the balance sheet and tax implications of their operating lease agreements and procedures now. Levin Swedler Kennedy can help evaluate the impact of your company’s operating leases to ensure compliance with the latest FASB regulations and procedures.
Written by: Dane Schaffer