Editor’s Note: On July 17th, 2019 the FASB proposed delaying effective dates for four key accounting standards (accounting for leases, credit losses, hedging and long duration insurance contracts). Check out our blog, FASB Proposes Delay in Major Accounting Standards for more information.

On February 25, the Financial Accounting Standards Board (FASB) finalized its new rule on accounting for leases. It’s expected to result in sweeping changes to financial statements of companies that currently have operating leases for real estate, fleet vehicles and equipment. The effects will reach companies in a broad range of industries, including retail, construction, transportation, banking and manufacturing.

Capital vs. Operating Leases

Under existing U.S. Generally Accepted Accounting Principles (GAAP), companies that lease assets (lessees) must report lease obligations on their balance sheets only when they’re similar to financing transactions, such as rent-to-own contracts. For example, an airline that leases a jet for most of the equipment’s useful life and can purchase it for a nominal price at the end of the lease term would likely classify this arrangement as a capital (or finance) lease. Conversely, a retailer that enters into a three-year lease for a strip mall storefront or a ten-year lease for its headquarters would likely classify these arrangements as operating leases. Capital leases are reported on the balance sheet, but operating leases are not.

Under U.S. GAAP, companies ask four questions to determine how to classify leases:

1. Does the lease transfer ownership of the property to the lessee?
2. Does the lease contain a bargain purchase option?
3. Is the lease term equal to 75% or more of the estimated economic life of the leased property?
4. Does the present value of minimum lease payments, excluding executory costs, equal or exceed 90% of the fair value of the leased property?

If you answer “yes” to any of these questions, the lease is generally classified as a capital lease.

Traditionally, most companies have, to the extent possible, structured their leasing agreements to look more like simple rentals so that they can keep them off of their balance sheet.

Balance Sheets Beware

Accounting Standards Update No. 2016-02, Leases (Topic 842), changes the rules of the game when it comes to the balance sheet. The revised guidance requires companies to record all leases as “right-to-use” assets with corresponding liabilities, initially based on the present value of lease payments. In other words, no distinction between operating and capital leases is made on the balance sheet under the updated guidance. Leases with terms of less than 12 months may be exempt from being capitalized, however.

Many investors and creditors applaud the new standard for providing greater transparency about the amount, timing and uncertainty of cash flows related to long-term leases. Compared to companies that own assets outright or already report capital leases on their balance sheets, companies with unrecorded obligations from operating leases may appear healthier and more creditworthy to stakeholders who don’t take time to read footnote disclosures. In effect, the new lease standard helps to level the playing field.

Possible Side Effects

Businesses worry that the costs of the new standard outweigh the benefits; however, adding operating leases to the balance sheet may draw more attention to these obligations. Specifically, they’re worried that implementing the new standard could lead to downgraded credit ratings, difficulty obtaining loans and violations of debt-to-equity loan covenants.

The changes also will increase recordkeeping costs, especially for multinational companies that must follow both the FASB’s new leasing standard and the International Accounting Standards Board’s (IASB’s) new leasing standard, which was issued in January 2016. Originally, the FASB and the IASB had planned to issue a converged standard on leases. But the project fell apart, primarily because the boards couldn’t settle their differences on how to report leases on the income statement. So, they decided to issue separate, nonconverged standards.

As companies add lease obligations to their balance sheets and expand their disclosures to comply with the updated guidance, they’ll need to keep track of more details about the terms and assumptions underlying their estimates of the fair value of leases. In some cases, the new standard could cause companies to reconsider their decisions to lease (rather than buy) assets and require more judgment calls each period than under the existing rules.

On the upside, the FASB’s new standard generally won’t change how leases are reported on the income statement or the statement of cash flows. Moreover, the accounting rules will continue to align with how lease expenses are reported under U.S. tax law. Accounting for companies that own leased assets (lessors) also will remain largely unchanged from existing practice.

Plan Ahead

The FASB has given lessees ample time to implement its updated lease accounting standard. For public companies, it goes into effect for annual financial statement periods that begin after December 15, 2018. Private companies have an extra year to comply. Early adoption is also permitted. The transitional guidance calls for recognition as of the beginning of the earliest period presented using a modified retrospective approach…including a number of potential expedients that companies may want to apply. This guidance needs to be evaluated carefully.

As the effective date approaches, we can help you implement the lease accounting changes and prepare comparative statements, as well as forewarn stakeholders about the impact.