By Ralph Petta
From the May/June 2016 Issue
After many years of anticipating its revision, the approval of the new lease accounting standard in February 2016 by the Financial Accounting Standards Board (FASB) means facility management and procurement departments can now move forward and prepare to adopt it. The new standard will not impact the ability of companies to acquire productive equipment or to enjoy the benefits of financing. There are many reasons to lease equipment, and the primary reasons will remain intact under the new rules, from maintaining cash flow and preserving capital to obtaining flexible financial solutions and avoiding obsolescence.
What’s Changing? What’s Not?
Many of the lease accounting changes are relatively neutral. The biggest change is that the new standard will change how operating leases are accounted for on corporate balance sheets. Instead of appearing as a table of future payments in the footnotes, these will appear on the balance sheet, but as a non-debt liability. The new rules have no impact on the income statement. There is a limited effect on debt covenants. The rules for classifying whether a new contract is a capital (finance) or an operating lease are virtually the same as before under generally accepted accounting principles (GAAP). Finally, the capitalized asset cost with operating leases will be lower compared to a loan or cash purchase so it is still important that the lease be an operating lease even though it is capitalized.
In considering the lease accounting changes, facility management leaders will want to understand the impact their equipment decisions will have on their organizations. For one, an organization’s credit rating should not change just because the FASB changed the rules for recording and capitalizing operating leases. Bank lenders and credit analysts already take into consideration the operating lease obligation included in a company’s footnotes. They estimate the value of the implied asset and liability created by operating leases to adjust their measures and ratios used to make credit assessments. The proposed formula to capitalize operating leases under the new rules is substantially the same as the method used by rating agencies today.
The new rules will be implemented retroactively, so all operating leases (except for short-term leases) will need to be capitalized in the financials reported in the transition year. If comparative balance sheets and P&L statements are presented, the operating leases must be capitalized in the earliest balance sheet. This means the impact may be sooner than one might realize.
Whether a company needs to recognize all leases on the balance sheet depends on the lease terms and conditions. If reporting under International Financial Reporting Standards (IFRS)/U.S. GAAP, the answer is yes. However, if the contract duration is equal to or less than 12 months, the off-balance sheet approach previously used for operating leases applies. If the contract qualifies as a service, the contract does not have to be recognized on the balance sheet. For IFRS companies, the lease does not have to be recognized if the value of the asset is low (with a benchmark less than $5,000), irrespective of term. (Note: This is not the case under U.S. GAAP.)
With the new standard scheduled to take effect in 2019 for public companies and a year later for private firms, now is the time to prepare. The following are five areas to address that will help facilitate the lease accounting changes for the business.
1. Inventory all equipment lease and rental contracts. Knowing the amounts and nature of contractual obligations and terms of leases will enable facility leaders to understand the company’s accounting and tracking needs.
2. Identify IT/software requirements. To determine if the technology in place will meet the new standards, ask your accounting software vendor how they plan to support the changes.
3. Review debt covenants. Although the lease accounting changes will have limited effect on debt covenants, discuss fully any implications with your bank or creditors.
4. Seek out industry expertise. In addition to getting accounting expertise, facility management leaders and their colleagues will want to consult with equipment finance providers. Providers have the experience to help assess the possible impact of the changes on current and future leasing.
5. Enact a plan. With the information gathered, facility leaders can start planning the budget and resources necessary for updates and systems changes to support the new rules.
While change may seem inconvenient at first glance, re-examining and assessing business processes to accommodate the lease accounting changes could reap unexpected advantages. Better information and controls can improve tracking and asset management, avoid redundancies, and allow facility management and procurement departments to negotiate better lease terms throughout the organization.
Disclaimer: This information is a summary only and does not constitute financial advice. Readers should obtain their own independent accounting advice that takes into account all relevant aspects of a particular lessor’s or lessee’s business and products.
Petta is President and CEO of the Equipment Leasing and Finance Association (ELFA), the trade association that represents companies in the equipment finance sector, which includes financial services companies and manufacturers. ELFA, its members, their customers, and other stakeholders engaged constructively with the FASB in its mission to revise lease accounting rules. For more information on equipment financing, visit www.EquipmentFinanceAdvantage.org.
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