What You Need to Know About the New Lease Accounting Standard
In January of 2016, the International Accounting Standards Board (IASB) issued its new lease accounting standard, which has been in development for years with the Financial Accounting Standards Board (FASB). The FASB released its own version of the standard weeks later.
While there are many details, nuances, and even differences between the IASB and FASB versions of the new standard, the key takeaway is that accounting requirements for reporting leases on financial statements, which have been the same for more than 30 years in the U.S., are changing in a big way.
What Exactly Is Changing?
Previously, operating leases for everything from offices and cars to copiers and phone systems were not recorded as liabilities on the balance sheet. Because you didn’t own the asset, it didn’t have to go on the balance sheet. If you bought or financed a car, it would go on the balance sheet. If you leased a car, it would not.
When the new lease accounting standard goes into effect, if you have an obligation to pay for something, even a leased asset that you don’t own, it has to be on your balance sheet as a liability. There are very few exceptions, one of which is leases of less than 12 months.
For example, rental commitments have always been disclosed in the notes to the financial statements but not as a liability on the balance sheet. If you have a long-term lease on a property, the present value of that payment stream must go on the books as a liability. In addition to reporting leased assets, there are a number of provisions to discuss with your accountant, such as lessor vs. lessee accounting models, embedded leases, reassessments, and disclosures.
The goals of the new standard are to bring transparency to lease assets and liabilities, prevent companies from manipulating the system, and make it easier to compare companies that lease and those that borrow to buy.
Potential Issues with Banks and Lenders
Most bank documents have financial covenants related to tangible net worth, and/or debt to equity. In other words, what’s your liability compared to your equity? This new standard adds a bunch of new liabilities to your balance sheet but will not change your equity. This will negatively impact your debt-to-equity ratio.
Bank covenants typically require liabilities to be no more than three times your equity. If documents aren’t rewritten to reflect the new lease accounting standard, you could fall out of compliance with your bank covenants and have issues with the bank and other lenders.
Keep in mind that banks are facing intense scrutiny from regulators, and bank personnel are still being educated about the new lease accounting rules. In a best-case scenario, the bank will simply amend the covenants. The lender may forgive noncompliance but make you pay for it with fees or higher rates. The answers on this are still to be determined.
What Should Businesses Do to Prepare for the New Lease Accounting Standard?
The new standard will be effective for public companies in 2019 and private companies in 2020. At first glance, that may seem like a lifetime away. However, because so many of your legal obligations will be affected, including most new lease agreements that you may enter into this year or next, it’s important to be proactive. Remember, the rule will impact leased offices or buildings, cars, phone systems, office equipment, copiers, data center technology and any other asset that is leased.
Inevitably, many businesses will wait until they get a notification of noncompliance from the bank and then scramble to fix the problem. That approach isn’t helpful for anyone. Have a conversation with your accountant about the new standard and how they plan to approach it. Create an inventory of leases that is complete, accurate and current. Develop a process for gathering and reporting leases. You may have to rethink your decision-making approach when it comes to leasing vs. buying.
Have a conversation with your bank and lenders so they know in advance that your documents need to be adjusted to reflect the new rules. Start a dialogue now so everyone is on the same page instead of waiting for problems to happen.
Like leases themselves, the new lease accounting standard is complicated. Start preparing and educating yourself now.