The Financial Accounting Standards Board (FASB) issued an updated lease accounting standard (ASU 2016-02) in 2016 to increase transparency and comparability among organizations that engage in leasing activities, as well as to improve financial reporting and disclosures of key information about leasing arrangements.
Implementation of the new lease accounting standard had been delayed for several years, but it is applicable for all private companies for fiscal years beginning after December 15, 2021 (i.e., calendar year 2022). Public companies adopted the standard in 2019.
The most significant impact of the standard is the requirement to recognize a majority of operating leases on the company’s balance sheet as assets and liabilities. While it will create significant changes to an entity’s balance sheet and the accounting for leases, it may have a greater impact on loan covenants and financial metrics.
If your company engages in leasing activities, it is critical to proactively evaluate the impact of the new lease accounting standard on debt covenants and your financial statements.
Here is a list of implementation recommendations and considerations for your company:
Develop an implementation strategy.
- Identify available resources and a champion for the project.
- Evaluate existing leases and service agreements to identify all operating leases and finance leases.
- Evaluate software considerations.
- Consider accounting policy elections, including available practical expedients. Some examples include:
- Waiver of classification reassessment of active leases
- Exclude leases of 12 months or less (short-term lease)
- For private companies, the risk-free interest rate can be used instead of the incremental borrowing rate
- Potential elimination of the need to separate non-lease components from lease components
- Determine transition year financial statement presentation.
- Recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach; or
- Treat as a cumulative-effect adjustment to the opening balance of retained earnings in the period of adoption
Evaluate terms for new leases and upcoming lease renewals.
- Consider whether terms can or should be modified to change the accounting treatment.
Determine the impact to the balance sheet and financial ratios.
- Accumulate information about the cash flows associated with all of your leases.
- Perform a present value calculation of the future payments.
- Pro-forma financial statements to show effect.
Evaluate third-party agreements, such as those with banks or others that have clauses related to the balance sheet.
- Determine if changes in financial reporting impact financial covenants.
Communicate with impacted third parties.
- Work with your banker to make sure changes resulting from the new accounting treatment do not cause you to be in violation of financial covenants.
- Communicating with your banker and others about the impact prior to full adoption is highly recommended. This will provide the opportunity for both parties to confirm agreement regarding how they will treat the changes.
Kreischer Miller can assist you with implementing the new lease accounting standard. Our process involves the following steps:
- Review existing contracts and assist management in determining which arrangements qualify as leases under the new standard.
- Assist management in determining the proper classification of leases (operating vs. finance).
- Assist management in accounting for leases, including the calculations of the right-of-use assets and lease liabilities, as required under the new lease accounting standard.
- Develop pro-forma financial statements to show the effect of the adoption of the new lease accounting standard on your financial statements.
- Determine the impact of the new lease accounting standard on your financial ratios, debt covenants, and loan agreements.
- Assist management in communicating the impact of the required changes to lenders and other third parties.
- Assist in developing accounting policies and internal controls to cover the following areas:
- Classification of leases
- Separation of lease components vs. non-lease components
- Exemption for short-term leases
- Related party leases
- Financial statement presentation matters
As mentioned, for calendar year companies, the effective date for the lease accounting standard was January 1, 2022. For companies that have not started their analysis or are in the early stages of implementing the lease standard, we advise you to take action now. Those who implement this will have a more accurate depiction of their financial statements for not only third party relationships, but also for themselves.
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