Lease Accounting: Prepare Now for New Standard
If you feel like the new lease accounting standard has been years in the works, you’re right. The good news is, for better or for worse, the new standard is here.
Most private companies are now required to adopt the new accounting standard ASU 2016-02, Leases (Topic 842) for reporting periods beginning after December 15, 2019. Companies with a December 31 year-end, that reporting period will be January 1 through December 31, 2020. This update will result in placing most operating leases with terms longer than a year onto a company’s balance sheet. Below are some tips to help make your implementation as smooth as possible.
It’s not too late to get started, but do not underestimate the time it will take to implement. The first step is to gather all of your operating leases for items such as office space and equipment. This may be easier said than done for most companies, as lease contracts may be stored in different places throughout an organization or at multiple locations. It is especially challenging for companies with an overseas presence, as contracts may be written in the local language and not always in English.
Companies with large lease portfolios may need to look into new IT tools to help track these contracts. To avoid becoming overwhelmed, some companies only are considering options that provide end-to-end lease management, accounting and standardized reporting. It is important to ensure the IT option selected is in compliance with the standard and to ask the vendor questions, such as, “What happens when the discount rate changes?” or “What happens if you need to change the leases useful life or payment amount?” Some companies are investing in new software but are still producing journal entries manually, while others plan to continue using old-fashioned spreadsheets.
Once you have a way to organize and monitor leases, you need to assess the quantity of leases and dollar value of the future amount owed. When performing the calculation to establish the balance for recording, an incremental borrowing rate will need to be determined. This is a financial statement estimate that will need to be identified in financial statement note disclosures. An incremental borrowing rate is the rate of interest a company would have had to pay to borrow the money to purchase the asset.
Financial Statement Impact
Financial statements will look different with new line items on the balance sheet for the right-to-use asset and the corresponding liability. Footnote disclosures will need to be updated. Lessees are now required to disclose any significant leases they have entered into but are not yet effective, which is something many companies may not have been tracking previously.
Talking to Lenders
An important next step for companies that hold notes payable or lines of credit is to look at the debt covenant ratios. The most common ones are cash flow ratios and leverage ratios, such as the current ratio, debt to equity and debt to EBTIDA. The new standard could impact all these ratios since the right-to-use asset for lessees will be classified as a non-current asset and the right-to-use liability will be classified into current and long-term liabilities.
Companies could be out of compliance with their agreements because of implementing this standard, which is why it’s recommended you talk with your banker now to determine if these new assets/liabilities will cause your organization to fall out of compliance with debt covenants. If they are out of compliance, those agreements will need to be renegotiated or banks will need to grant waivers.
A long-term consideration when entering into new leases is that traditional benefits of leasing versus buying might have decreased or even vanished because of implementation of the new standard.
KEY TAKEAWAY: The time is here to get a game plan together and start implementing the lease standard effective for year reporting periods beginning after December 15, 2019, for most private companies. Do not underestimate the time it will take, the number of departments involved in this process or the effect it will have on your financial statements and debt convents.
About Ericksen Krentel
Ericksen Krentel CPAs and Consultants, founded in New Orleans, Louisiana in 1960 with offices in New Orleans and Mandeville, believes that serving as the clients’ most trusted adviser is grounded in going beyond the numbers.
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