Lease Reporting Changes on the Horizon

Currently, leases are categorized as operating or capital leases.  Generally an operating lease impacts the income statement only, with an annual charge to rent or lease expense.  Typically, the rental of office or warehouse space is considered an operating lease.  Under a capital (or finance) lease, the lessee is presumed to implicitly own the asset which is reflected on the balance sheet with a corresponding liability.  Income statement presentation consists of amortization of the asset and interest expense on the debt.  Fixtures, equipment and vehicle leases that contain bargain purchase options or directly transfer ownership at the end of the lease term are typical capital leases.

So what’s new?

You just signed or renewed a multi-year building lease or maybe you’re in the middle of a long term equipment lease.  You subsequently review your financial statements and notice what may be a significant asset and related liability on your balance.  Under the new lease accounting standard (FASB ASC 842), what was once categorized as an operating lease now requires the balance sheet reflect a right-of-use (ROU) asset with a corresponding liability to make lease payments.  The expense on the income statement will be basically unchanged with a charge to lease expense based on the terms of the operating lease. On the balance sheet the right-of-use asset and the liability will be amortized over the lease term using the interest method. Things get more complicated with the inclusion of initial direct costs, lease incentives and escalating lease payments.

Accounting for the capital or finance lease remains relatively unchanged.  In addition, there is an exception for short term leases that, at inception, have a lease term of no more than 12 months and do not transfer ownership to the lessee.  The lessee can elect to not apply the requirements of the new standard to these short term leases.

For presentation purposes, both operating and finance right-of-use assets must be presented separately from other fixed assets on the balance sheet.  Income statement and cash flow statement presentation is relatively unchanged.

What needs to be provided?

For disclosure purposes, lessees are required to provide both qualitative and quantitative information, including the following:

1. A general description of the lease, information regarding variable lease payments and the existence of terms to extend or terminate the lease
2. Information regarding significant assumptions and judgements
3. Related party transactions and terms
4. The existence of an residual guarantees
5. Narratives about options recognized and not recognized
6. Determination of the discount rate used to determine the lease liability
7. Restrictions or covenants imposed by the lease
8. Quantitative disclosures such as finance or operating lease costs, including amortization and interest expense; variable lease costs; short term lease costs; and maturity analysis

The good news is you have time to prepare.  The standard is effective for non-public entities for annual periods beginning after 12/15/19, although early application is permitted.

What questions do I need to ask in order to be prepared for the new lease reporting requirements?

Some things to think about:

1. How will the inclusion of a right-of-use asset and related liability impact my balance sheet? Will there be an impact on operating ratios?
2. Do I have existing debt covenant restrictions imposed by current lenders and will my lease trip any of the restrictions? How soon should I discuss with my lenders?
3. Do I have the internal accounting capability to quantify and measure the new requirements of an operating lease? How long will it take me to comply and what will the cost be?
4. Have I spoken with my external accounting professional?

Your accountant and advisor is here to discuss both current and future tax planning needs. Contact Alloy Silverstein for additional guidance on the new lease reporting rules before they take effect.