Updated accounting rules for long-term leases took effect in 2019 for public companies. Now, after several deferrals by the Financial Accounting Standards Board (FASB), private companies and private not-for-profit entities must follow suit. The new standard will apply to annual reporting periods beginning after December 15, 2021, and to interim periods within fiscal years beginning after December 15, 2022.
Unlike current generally accepted accounting principles (GAAP), which requires only capital-type leases to be recognized on the balance sheet, the new guidance directs that a lessee is required to recognize right-of-use assets and liabilities associated with all long-term rentals on the balance sheet for leases with terms of 12 months or longer. The magnitude of recognized right-of-use assets and liabilities will be determined as a product of the lease term, required payments and applicable discount rate used to calculate the present value of those obligations. While entities may be tempted to automatically exclude leases that are month-to-month or have a term of 12 months or less, the guidance specifies that adopters must utilize an “expected outcome” approach and must consider other economic factors when determining the applicable lease term.
The new standard also directs changes to required disclosures to help financial statement users better understand the amount, timing and uncertainty of cash flows arising from the leases. Companies will need to disclose, in the notes to the financial statements, more information about the nature of its leases, the significant judgments made in applying the requirements of the new standard and various other amounts and features related to particular leasing activities. This area is probably the most significant change that would require the assistance of a CPA to ensure you have all bases covered.
Implementing the new lease standard could take more time and money than most organizations realize. There are several specific issues that you’re going to need to carefully navigate to ensure a cost-effective and successful transition to the new standards. To help create a path to success, thoughtfully prepare in these areas:
- Compile a complete population of your leases, along with applicable lease terms and required payments. Gathering of all documentation that has leases can be difficult and time-consuming, but it will help you have a solid idea of what exactly you’ll need to deal with. Don’t forget to look for related party leases, even if they’re unwritten.
- Select the best lease software for your company’s needs. You’ll need to look at the style and features to determine which one has the best match to your company’s needs. This software can help minimize your company’s costs while providing a smooth transition to the new standard.
- Identifying embedded leases. Maintenance or service contracts can be described as a lease agreement but contain identified assets that are controlled by your organization, making it an “embedded” lease. Under the new standard, you’ll need to capitalize this type of asset and account for it on your books, making it an important, but difficult to locate, type of lease.
- Decide on the discount rate you should use. There are some choices in discounting your lease payments to present value, then capitalizing on your accounting books, which can use implicit rates, incremental borrowing rates or risk-free rates, but these can also impact metrics including bank ratio covenants.
- Work with your accountant. Communicate early with your auditor or accountant in order to understand their process of auditing or reviewing the leasing activity and financial statement disclosures in order to aid you with developing internal accounting policies, procedures and internal controls around the new leasing standard.
It’s important that you take a test run in applying the new guidance to see how it impacts the presentation of your balance sheet. The right-of-use asset recognized under the new guidance would be classified as a non-current asset, while the current portion of the lease liability would be classified as a current liability. This could potentially have a substantial unfavorable impact on working capital, fixed charge ratios or similar liquidity and liability-sensitive ratios. What was once considered a healthy company might now appear to be a poor credit risk, and the decreased ability to obtain funding could have a real, adverse effect on the financial health of the company.
If you have any questions or need assistance with implementing the new lease standard, please contact any of the professionals at Dannible & McKee, LLP. Visit dmcpas.com to learn more.