Who is Effected?
In 2016, the Financial Accounting Standards Board (FASB) effectively turned the lease accounting rules upside down. The new rules, which became effective on January 1, 2019, for public companies using a calendar year, are scheduled to be effective for private companies using a calendar year on January 1, 2020.
The changes will significantly affect the financial statements of every company that leases property or equipment, especially those that rely on operating leases (i.e., leases 12 months or less that do not include an option to purchase the underlying asset that is reasonably certain to be exercised).
All leases longer than 12 months in duration must be recorded on the company's balance sheet. That's a big change from the current rules, under which operating leases were recorded as a rent expense that didn't appear on the company's balance sheet. Under the new rules, with limited exceptions, all leased property or equipment is considered a right-of-use asset and must be recorded as such on the company's balance sheet.
Similarly, all lease payments are recorded as liabilities rather than operating expenses. This change affects other things as well. For example, interest expenses must be calculated as a cost of the lease and allocated over the term of the lease on a straight-line basis. This affects financial reporting across the board, including calculations for earnings before interest, taxes, depreciation and amortization as well as depreciation and certain tax calculations. The new rules also require additional quantitative and qualitative disclosures designed to enhance the transparency of a company's financial statements and to allow greater comparability between similar companies.
Note that lease arrangements are contracts that can be structured as part of a larger contract rather than as a separate lease agreement. For example, a master lease can contain different terms for each type of property or equipment in the lease.
In addition, month-to-month leases come under special scrutiny, particularly if the lease is between related parties.
The tests include whether the lessee is
- Depreciating significant improvements to the property for more than 12 months
- The sole user of assets and is paying the lessor to service the debt
- Guaranteeing the lessor's debt
- Able to relocate without incurring a great expense
Other important considerations under the new rules include the following:
- The definition of a reasonable useful life for the asset
- Whether the asset has any useful life at the end of the lease
- Who has title to the asset at the end of the lease
- The cost of the asset to the lessor is at the end of the lease
- The lease renewal options (e.g., what if the lease renews annually?)
- What happens if there is no formal lease agreement?
The bottom line is that all businesses must take the time to review all their lease agreements, whether they are separate agreements, contained in a master lease or are part of another contract, and rework how their leased assets are accounted for and reported so they can be in compliance by January 1. The change involves the company's processes and procedures for recording leased assets.