We'll address the required accounting changes, the potential impact to financial statements, as well as the importance of implementing proper technology and resources to ensure compliance and to mitigate risk.
Operating Leases Recognized on the Balance Sheet
Under the new standards, operating leases will now be reflected on the balance sheet, eliminating them as a vehicle for off-balance sheet financing.
A liability for the lease payments will be created, as well as any assets connected with the right to use the asset over the term of the lease.
Loan Covenants on Existing Debt
This might seem like a simple accounting change, however, the additional liabilities could place your company in violation of debt covenants on existing debt.
The addition of both an asset tied to the right to use the leased item and the corresponding liability for the lease payments might impact several of your company's financial ratios that are part of the lease covenants on other debt, including:
- The current ratio. The increase in short-term liabilities (the lease payments) will decrease this ratio.
- Debt to equity ratio. This ratio could be affected to the inclusion of the total value of the lease as a long-term liability.
- Debt service coverage ratio. The inclusion of the operating liability without an offsetting cash flow item could impact this key measurement going forward.
You will want to review your debt covenants to gauge the impact. If you foresee a problem, we suggest that you contact your lender to discuss and resolve it.
Under the new ASC 842 standards, the interest cost for operating and for finance leases will be presented a bit differently.
For finance leases, the interest and the amortization of the lease are presented as separate line items. As a result, the expenses can be front-end loaded because of the separate interest on the lease liability.
The interest and the amortization components for an operating lease are combined into a single line item, resulting in a more straight-line impact over time.
Financial Statement Disclosures
Under the current standards, operating leases are disclosed in the notes to the financial statements. The existence of these leases, and the liability to make lease payments, are not a secret, but a user of the statements would need to sort through the notes to uncover their existence.
These disclosures are generally unaudited and not uniform from company to company. Including this information on the balance sheet will bring it to the forefront to ensure more uniform accounting for these leases from company to company.
ASC 842 will significantly increase and upgrade the disclosure for both lessees and lessors. This will include both quantitative and qualitative disclosures.
Examples of some of the qualitative disclosures now required include:
- Information about the nature of the leases
- Information about leases that have not yet commenced, but will provide significant benefits obligations for the lessee in the future
- Information about assumptions regarding the lease obligation
- Determination as to whether the contract is a lease
- The allocation of consideration provided by the lessee between lease payments and non-lease payments
- The discount rate for the lease and how it was determined
- All terms and conditions of a sale-leaseback arrangement
- Lease transactions between related entities
- Whether the company has an accounting policy for the short-term lease exemption
Examples of quantitative disclosures that are now required include:
- Lease costs segregated between the amortization of the right-to-use asset and the interest on the lease liability
- Operating lease costs
- Short-term lease costs, with an exception for leases with a term of one month or less
- Variable lease costs
- Any net gain or loss recognized in a sale-leaseback transaction
- A maturity analysis of all lease costs for the five years subsequent to the date of the balance sheet and the total for leases maturing after that time
- A reconciliation of the undiscounted cash flows from leases to the total lease liability reflected on the balance sheet.
Amounts will be separated between operating and capital leases for the following items:
- Cash paid for the amounts included in the lease liabilities reflected on the balance sheet, separated between operating and financing cash flows
- Noncash information arising from obtaining right-of-use assets
- The weighted average aggregate remaining lease term for all leased assets
- The weighted average lease discount rate
Note that many of these disclosures were required under the previous ACS 840 rules, but this requirement extended only to capital leases and not to operating leases.
Adding these disclosures for all leases regardless of lease classification is a significant change under the ASC 842 standards and will require some major accounting and reporting changes for many companies, including changes to internal systems and accounting processes to ensure that the proper data is captured.
Preparing for the new ASC 842 standards has been a daunting process for many companies. The ongoing compliance and reporting will be challenging, as well.
Many companies will need to make internal changes in their accounting systems and their processes regarding capturing the data needed to accommodate these changes, and to meet the new reporting and disclosure requirements.
The scope and magnitude of these changes will vary for every company. In some cases, meeting the new reporting requirements will require a significant overhaul in these processes and systems.
Some areas where the new requirements are likely to have an impact include:
Ensuring that you gather the proper lease data
A major issue for many finance departments is the employees gathering and accounting for this lease data are not leasing experts. In some cases, the original lease documents may not always be readily available, and/or they might not clearly spell out the data that is needed to meet the new reporting requirements.
This may sound simplistic, but a great first step is to simply gather and organize all relevant documents pertaining to leased assets. These may be in paper form or reside on your company's system. It's also important to let your finance staff know that it’s OK to reach out to the lessor firm to get the documents or information needed.
Ensuring that your company complies is in everyone’s best interest, since you are a customer. The lessor firm certainly doesn’t want to be perceived as being difficult to work with, and it’s in their best interest that your company is financially successful.
Ensure that your internal accounting systems are ready
A critical part of the process for ongoing compliance is ensuring that your internal systems collect and account for the necessary lease data going forward. For many companies, this will include updating accounting and financial software.
It's important to select software and applications that mesh well with your current systems. This will likely entail working with your banks, your outside accounting firm, and perhaps a consultant, if needed.
Since there is a transitional reporting requirement for ASC 842, your company will need to provide comparative financial statements for a two-year period showing results under both the old lease reporting standards and the new standards.
Review and update your lease accounting procedures and controls pertaining to leases
This might require some major changes within the finance organization.
The new reporting requirements are expected to cast more attention on how companies handle all aspects of the leasing process. This includes lease negotiations, lease implementations and lease terminations. It is a best practice to document these and other processes to ensure uniformity in the handling of each lease going forward.
Some steps to consider:
Analyze the vendors who serve as lessors for various types of assets. Is there a concentration for certain asset types, such as equipment, real estate, vehicles, etc.?
Analyze lease discount rates by lessor, by asset type, etc.
Analyze the disposition of leased assets. Is action taken on leased assets upon expiration or are certain types of assets routinely held for usage after the expiration date of the lease?
Analyzing these and other aspects of leases and leased assets can yield vast amounts of information that can be used to define and implement procedures surrounding the leasing of assets.
The result of this type of analysis could go far beyond compliance with the new standards and lead to improved bottom line results including:
- Improved criteria to select lease vendors for specific asset types
- Target discount rates and lease terms for specific asset types
- Matching lease terms for various types of assets to the time frame for which they are typically needed
The new lease accounting standards are far-reaching and may require significant changes in your internal systems, process and controls surrounding leases. The analysis in getting to a point of compliance may also yield valuable data that can be used to guide future leasing and financing decisions.
Need Help Navigating the FASB’s ASC 842 Changes?
If you need to discuss how your equipment acquisition and finance strategy might need adjustment from these recent changes, connect with your PNC Equipment Finance representative today.