The new lease accounting standard (ASU 2016-02) released by the Financial Accounting Standards Board in 2016 requires the recognition of lease assets and lease liabilities on the balance sheet. Under previous accounting guidance, assets and liabilities attributable to operating leases were not reflected by lessees on their balance sheets. Many leases for real estate are classified as operating leases and, therefore, are not reflected on the balance sheets of lessees.
This new lease accounting standard may have a material impact on companies that engage in significant leasing activities, particularly real estate leases. As you prepare to implement these changes, here are four things to consider:
- Pro Forma Financial Statements – Since this new standard may significantly change a company’s balance sheet, it may be a good idea to calculate the operating lease assets and liabilities for all operating leases – including those for real estate – and develop pro forma financial statements showing the impact of adopting the new standard.
- Impact on Loan Covenants and Financial Metrics – Many companies have loan covenant requirements based on leverage ratios or total liabilities. Leverage ratios could drastically change due to the “gross-up” of the balance sheet and may include material increases to liabilities for lessees in real estate leases. Consider discussing the impact on your loan covenants with your lender or other third party users of your financial statements sooner rather than later to avoid surprises.
- Practical Expedient for Combining Non-Lease and Lease Components – Certain real estate leases include non-lease components such as operating expenses covering taxes, insurance, and common area maintenance. The new guidance requires companies to account for the components separately. However, lessees may elect an accounting policy that would allow non-lease components and lease components to be combined and treated as one single lease component for accounting purposes. This may simplify the accounting for real estate operating leases.
- Related Party and Short Term Leases – It is common for companies to lease real property from a related party. Typically, these leases are short term (12 months or less, or even month to month). Lessees can make an accounting policy election and choose not to recognize a right-of-use asset and lease liability for any lease with a term of 12 months or less and that does not include an option to purchase the underlying asset that the lessee is reasonably certain to exercise. Consider evaluating leases with related parties and modifying the terms where appropriate.
There are sweeping changes coming with the new lease accounting standard, as many operating leases for real estate will be reflected on the balance sheet of lessees. The new standard is effective for fiscal years beginning after December 15, 2018 for public companies (i.e., calendar year 2019). For private companies, it is effective for fiscal years beginning after December 15, 2019 (i.e., calendar year 2020). Now is the time to evaluate the impact of this new standard on your business.
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