Almost every manufacturer leases equipment or real estate. For decades, companies were not required to report many lease-related assets and liabilities on their balance sheet. That is all about to change under a controversial new lease accounting standard that was issued in early 2016.
Shifting the reporting paradigm
Historically, under U.S. Generally Accepted Accounting Principles (GAAP), companies have been required to record lease obligations on their balance sheet if the lease is considered a financing arrangement, such as rent-to-own contracts for buildings or vehicles.
Companies must consider various rules to determine if they have a capital lease. First, if the present value of lease rental payments amounts to more than 90% of the asset’s value, the contract is generally considered a capital lease and the asset and liability are placed on the lessee’s balance sheet. The other factors that force a balance sheet approach include a determination to see if the lease transfers ownership at the end of the lease term, if the lease agreement contains a bargain purchase option or if the lease term is equal to 75% or more of the estimated economic life of the asset.
If any of these conditions are present, the lessee must report the lease on the balance sheet as a capital lease. If these conditions are not met, the lease is generally considered an operating lease and the lessee simply records the payments as expenses on the income statement.
The accounting rules have given companies significant leeway to structure deals to look like rentals. Investors and lenders often complain that this practice makes lessees appear more financially secure than companies that take out loans to buy the same assets. For some companies — such as trucking companies that lease their fleets of vehicles or manufacturers that rent all their warehouse space — lease payments represent significant financial obligations.
In February 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update No. 2016-02, Leases (Topic 842), which changes the way these obligations are reported. The new standard focuses on providing greater transparency in reporting future lease obligations by requiring lessees to recognize lease assets and lease liabilities on the balance sheet and to disclose qualitative and quantitative information about lease transactions, such as information about variable lease payments and options to renew and terminate leases.
Exempting operating leases
Manufacturers and distributors may be especially concerned about the impact the new standard will have on their financial statements and the compliance burdens it will impose. They tend to rely heavily on fixed asset leases and, therefore, may expect to suffer disproportionate adverse effects compared with companies in other industries. There may be concern that the new lease standard will upend loan covenants that require borrowers to maintain certain debt-to-equity ratios. In addition, there is apprehension that borrowing costs may increase for companies whose balance sheets look weaker with their operating leases included.
After fielding significant criticism, the FASB decided to make its final guidance less far reaching than its original 2013 proposal. The issued standard retains the requirement that companies record obligations to make payments on rentals of storefronts, equipment and vehicles as liabilities. But the FASB has decided that certain operating leases — those with terms of 12 months or less that are more akin to rentals as opposed to financing deals — will continue to be accounted for on the income statement as they are today.
Postponing the implementation date
Public companies are required to adopt the new guidance for interim and annual periods beginning after December 15, 2018. For private companies, the guidance is effective for fiscal years beginning after December 15, 2019.
The guidance requires companies to use a modified retrospective approach, which includes a number of optional practical expedients. A company that elects to apply the practical expedients will, in effect, continue to account for leases that commence before the effective date in accordance with the previous accounting standards unless the lease is modified. An exception is that lessees are required to recognize a right-of-use asset and a lease liability for all operating leases at each reporting date based on the present value of the remaining minimum rental payments that were tracked and disclosed under previous GAAP.
Despite the delay in the implementation date, proactive manufacturers should talk to a financial advisor today about how the lease standard is likely to affect their financial statements and debt-to-equity ratios in the future. Doing so can help preempt negative consequences related to this major change.
At Cassady Schiller, we can help you understand the new guidance and how it applies to your company. Feel free to contact us at firstname.lastname@example.org to set up a consultation.