In 2016, the Financial Accounting Standards Board issued the new lease accounting standard, Accounting Standards Update (ASU) 2016-02, Leases. The intent of the new standard is to increase transparency and comparability among organizations that engage in leasing, as well as to improve financial reporting and disclosures of key information about leasing arrangements.
Current lease accounting has been criticized for failing to meet the needs of financial statement users because it does not always provide a faithful representation of leasing transactions – there is a lack of recognition of assets and liabilities arising from operating leases on the balance sheet. The main objective of the new standard is that entities should recognize an asset and liability from a lease.
What is Changing Under the New Guidance?
Currently, generally accepted accounting principles in the United States (U.S. GAAP) require only capital leases to be recognized in the statement of financial position. Operating leases under U.S. GAAP are reflected in the financial statements as rent expense and future commitments under operating leases are included in the note disclosures to the financial statements. Operating leases are not currently reflected in the statement of financial position.
ASU 2016-02 requires entities to distinguish between operating leases and finance leases, and recognize the assets and liabilities that arise from all leases at lease commencement as a right-of-use asset and corresponding lease liability. The lease liability is initially measured at the present value of lease payments using the rate implicit in the lease when readily determinable, or the lessee’s incremental borrowing rate.
The recognition, measurement, and presentation of expenses and cash flows arising from a lease by a lessee have essentially remained unchanged from existing U.S. GAAP. For operating leases, entities will recognize a single lease expense on a straight-line basis in income from continuing operations. Amortization of the right-of-use asset and interest expense on the lease liability will be recognized for finance leases.
How Does the New Standard Impact Loan Covenants?
The changes in lease accounting may affect compliance with contractual agreements and loan covenants. In particular, leverage ratios could materially change with additional liabilities recognized in the balance sheet. Current ratios could also be affected due to current vs. long-term classification of lease liabilities. There should be no change to EBITDA since the classification criteria for distinguishing between finance leases and operating leases are substantially similar to the existing guidance.
Additionally, financial covenants including total liabilities or lease payments may be impacted and need modification.
When is the New Standard Effective?
The new standard is effective for fiscal years beginning after December 15, 2018 for public companies (i.e. calendar year 2019). For private companies, the guidance becomes effective for fiscal years beginning after December 15, 2019 (i.e. calendar year 2020). Early application is permitted for all entities. During this transition, entities are required to recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach.
The new lease accounting standard will create significant changes to an entity’s balance sheet and may have a greater impact on loan covenants. It is critical to evaluate the impact of these changes and communicate anticipated effects to your lender and other users of the financial statements well in advance of the implementation date. This will allow ample time to consider necessary modifications that may be required to loan documents, lease agreements and other related contracts.
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