As published in MicoCap Review Magazine
Are You Ready for Lease Accounting?
By: Corey Fischer
Managing Partner, Weinberg & Company, P.A.
One of the most significant changes in accounting in recent history is about to occur. The long discussed goal of recording lease liabilities on the balance sheet is now almost certain. Other than a determination of the transition and effective date, the Financial Accounting Standards Board (“FASB”) and the International Accounting Standards Board (“IASB”) have wrapped up their joint discussions on lease accounting, with final lease accounting rules expected to be issued by the end of the year.
This means the liabilities for leases will be recorded as liabilities on a company’s balance sheet (leases under a year in duration are exempted). The liability will be reduced as payments are made, with the payments being allocated to principal reduction and interest expense. Simultaneously, companies will record a leased asset upon inception, and such asset will be amortized to earnings over the life of the lease.
Business and the world of financial reporting have been functioning quite well for years without having the lease liabilities on the balance sheet, so why the need to change now? Well for one, there has always been a storm brewing within the accounting rule-making community that something just did not seem right. Since leases are real contractual obligations requiring the use of cash, the regulators have been questioning whether the financial position of a company could be accurate without inclusion of these liabilities. As the years rolled on, and spurred on by the joint convergence project with the IASB, the move to bring leases on the balance sheet gained momentum. Secondly, while issuers were happy with the existing method, many analysts and other users of the financial statements always considered leases as real liabilities, and often had to do their own calculations to determine actual debt of the company. The FASB and IASB boards have finally acted on the requests of users and analysts to require the balance sheet reflect these liabilities.
Almost every issuer of financial statements will be affected by this change. Most significantly, this change will affect companies that have significant real estate leases in multi-locations such as restaurants, retail stores and office units. Up until this point, most real estate and other leases were considered to be operating leases, and were not recorded on the balance sheet. Only a disclosure in the footnotes was made regarding the payment obligation. Other types of typical leases, such as major equipment leases whose terms were similar to ownership, will not be affected by this change because current accounting rules already provide for the recording of liabilities for capital leases.
Management needs to analyze what effect the new accounting will mean to the investment community. The change in the accounting will mostly affect the balance sheet, which will now include a long term lease asset, and a long term lease obligation. The change to the statement of operations and earnings should be minimal as the new calculations of amortization of the leased asset and the interest on the lease obligation will generally emulate the straight line rent expense used now for operating leases. Long term projections should not be significantly affected by the change. However, management should start the process now of recasting its projections to ensure such changes do not materially affect previously disclosed forecasts and goals.
In addition, management needs to consider how the inclusion of the new lease liabilities on the balance sheet will affect the calculations of leverage and other ratios used to monitor liquidity and performance of a company. Companies may find themselves in violation of existing bank or other financing covenants. Management will need to carefully analyze and identify what affect the new accounting will have on those indicators, and address those issues with lenders as soon as possible.
The implementation could have been much worse. The changes in the new pronouncement only pertain to Lessees. It does not affect Lessor accounting. The initial exposure drafts included significant recording requirements for Lessors that would have been extremely onerous from both the preparer and user perspective. The initial drafts also included what could have been very complicated provisions for leases in determining lease term (renewal options) and impairment considerations. The FASB did a great job listening to the feedback, and eliminated most of those requirements. What is left is a pronouncement that is more practical and less theoretical.
Lease accounting is on the horizon. It is not too early for management to start the process of addressing the issues that the impending new accounting requirements will bring. Most importantly, management should determine if it has the processes in place, and the human resources within its current accounting department to handle the increased reporting requirements. As often happens when implementing new accounting rules, preparers often encounter hidden complexities that may require the help of outside consultants.
Once you have mastered the lease accounting, there is no rest for the weary. New revenue recognition rules are on the way too!
Corey Fischer, CPA, is Firm Managing Partner of Weinberg & Company, a multi-office, PCAOB-Registered firm specializing in the audit, assurance and tax needs of micro and small cap companies. He has more than 25 years of experience, having worked with the Big 4 accounting firms, and as an SEC reporting officer for a number of NASDAQ-listed companies. He is based in Los Angeles, and is an expert in financial reporting, SEC compliance, raising debt and equity, mergers and acquisitions, and structuring accounting operations. Email: firstname.lastname@example.org or 310-601-2200.