To produce a product or deliver a service, business owners and managers will usually need office space, vehicles, heavy machinery and/or other equipment as their businesses grow. Choosing to lease a location or an asset rather than purchase it outright is often the smarter choice – the risks are lower, it offers an opportunity first to test the location or equipment, and sometimes, there are even valuable incentives offered by the lessor. When making these decisions, however, business owners often fail to consider how the lease will appear on the company’s financial statement – and understandably so. They may not realize just how much these assets can impact their bottom line. The Financial Accounting Standards Board (FASB) recently issued new regulations (ASU 2016-02) that significantly changed how leases are reported on the financial statement. Since the deadline for compliance is quickly approaching for public companies and certain nonprofit entities (December 15, 2018), it’s important to act now. To help clients, prospects and others understand the changes, and how it will impact them, JLK Rosenberger has provided a summary of the key points below.
Purpose of ASU 2016-02
Over the last few years, the lack of transparency in financial reporting had become a concern for rule makers. Under current regulations, there is an inconsistency in how leases are reported on balance sheets. Certain leases are required to be reported as a liability (along with a corresponding asset), while others are not. This created confusion among investors, analysts and other financial statement users as to the rights and obligations that lessees have in leasing agreements. Under the new regulations, companies will be required to report nearly every type of lease on the balance sheet, both as an asset and as a liability. In addition, there will be new disclosure requirements to help financial statement users understand the amount, timing and uncertainty of cash flows resulting from various leases.
ASU 2016-02 simplifies the reporting process by requiring both finance leases and operating leases to be reported on the balance sheet. Finance leases are long-term leases, and they have always been reported on the balance sheet. These types of leases are typically for the length of the asset’s useful life, and the owner is often responsible for repairs and upgrades to the equipment. Operating leases, on the other hand, had previously only been recorded on the income statement when a lease payment was made and had been left off the balance sheet altogether. Operating leases are shorter-term leases, generally for equipment that is upgraded frequently or used for only a set period. Going forward, these leases will be required to be shown on the balance sheet alongside finance leases. Businesses must record a right-of-use asset and a corresponding liability based on the present value of the lease payments. The only type of lease left off of the balance sheet are short-term leases. These leases, which are for less than 12 months, are only recorded on the income statement when a lease payment is made.
Preparing for Transition
The best way to begin complying with the new standard is to review all the company’s leases to determine which ones will be under the scope of ASU 2016-02’s. Managers can group leases that will receive the same accounting treatment. For example, if the company leases a fleet of vehicles for executives, they can all be treated the same way. Management will also need to make judgements or assumptions about their lease reporting. For example, they may need to establish standards that differentiate a non-lease component (goods or services provided apart from the actual lease, such as maintenance services on fleet vehicles) from a lease component. Along the way, management should make sure to document these judgements because they will play a major part in creating accurate disclosures for the required year-end reports.
The transition process can be difficult, and many companies will require the assistance of various internal departments beyond accounting to prepare for compliance, including some of the following:
- IT Department – The existing accounting software may not accurately document this lease information. Management may need to purchase different software, or they may need to work with their IT team to tweak their existing software.
- Tax Department – The tried-and-true corporate tax planning strategies may not fit with the new accounting regulations. The tax department can help management understand how the changes to the financial statements will impact the organization’s tax returns.
- Processing Department – The new disclosures require new and different information to be collected throughout the transition process and beyond. Management will need to not only know what information they need to collect but know how to collect it.
- External Relationships – Given that the company’s debt ratios will change under the new standard, management will need to meet with their banking representatives and creditors to prepare them for the changes.
While the changes outlined in ASU 2016-02 may seem straightforward, corporate entities, nonprofits and certain benefit plans need to conduct a thorough review of their processes to determine where changes need to be made. It’s important to understand not only how internal documentation and reporting processes will be affected but also the need to educate stakeholders on the changes and impact. If you have questions about the lease accounting changes or need assistance with the transition process, JLK Rosenberger can help! For additional information, please call us at 949-860-9902 or click here to contact us. We look forward to speaking with you soon.