Leases – What You Need to Know About the Changes Part I: An Overview
By Benjamin R. Ripple, CPA, Partner
Hopefully by now you have heard that the accounting for leases will be changing soon, and hopefully you have started looking at what effects this will have on your financial statements. Over the next couple of months, we will be covering various aspects of the new lease standard from a variety of points of view to help you get your arms around how this big change in accounting will affect your numbers.
First, let’s cover the basic question of when this change will happen. Nonpublic companies will be required to implement the new standard for years beginning after December 15, 2019. Public companies, as always, get to be the guinea pigs, and they have to implement for years beginning after December 15, 2018 (so now).
Second, let’s take a look at what will happen for lessees (tenants) and why FASB decided this was the way we needed to go. The big picture is that all leases that are expected to last more than 12 months will need to be capitalized on your balance sheet as a right-of-use asset and a lease liability. The last part of that statement is important. If you were planning to structure all of your leases as 12 months long with renewal options to cover the actual period that you wanted to lease the property or equipment, the new lease standard requires you to evaluate whether or not those options will be exercised, and any lease expected to extend beyond 12 months would need to be capitalized.
As to why, FASB has been working on getting all leases capitalized for years. The feeling has been that leaving operating leases off of the balance sheet has been understating liabilities. For example, Amazon’s 10-K filing for the year ended December 31, 2017 discloses that they have operating leases commitments of $22.8 billion. That amount is 17% of Amazon’s total assets. That is over seven times more than Oprah’s net worth. That is 5% of North Carolina’s GDP for 2016. That is not a small number; it is a very large number. And FASB felt leaving a liability that big to disclosure in the footnotes was misleading the users of the financial statements. So now, you get to capitalize your copier lease. Thanks Amazon.
Finally, let’s discuss the first steps that you need to take as you journey down this road of adopting the new lease standard. The first thing you need to do is take a moment of reflection. The sky is not falling, and the world is not coming to an end. This is just a new lease standard. Debits still go on the left, and credits still go on the right.
You should already have a good catalogue of what leases your company has entered. This was needed to get the disclosures for capital and operating leases correct historically. If you are a little concerned about whether or not your catalogue had been historically complete, now would be a good time to make sure you have identified all of the company’s leases.
Second, you should revisit your identification of each lease as operating or capital. While all leases longer than a year will end up on the balance sheet, there is still going to be a distinction between an operating lease and a finance lease and how to account for payments of those two types of leases. Luckily, determining whether a lease is operating or finance is very similar to how you had always determined between operating and capital. The main difference in this step is the bright line test of the lease term lasting over 75% of the useful life or the present value of the minimum lease payments exceeding 90% of the fair value of the asset has been replaced with the terms “the major part of the remaining economic life” and “substantially all of the fair value of the underlying asset.”
Once you have a good inventory of your leases and their classification as either an operating lease or a financing lease, you are ready to start tackling the specifics of how to account for them. We will be tackling those specifics over the rest of this series of articles. In our next installment, we will tackle accounting for operating leases.
If you have any questions or concerns surrounding the new lease standard, please reach out to your trusted accounting advisors sooner rather than later.
Benjamin R. Ripple Partner, Assurance Practice Leader, CPA
Ben is a partner in BRC’s assurance services. Since starting his career in 2001, Ben has worked with clients ranging from family-owned companies, to multinational corporations, to not-for-profit and governmental entities requiring A-133 audits. Ben’s industry experience includes: Manufacturing and distribution Hospitality, including restaurants and hotels Investment companies Governmental and not-for-profit entities Affordable housing […]