If it feels like you’ve been hearing about changes to lease accounting for forever, you’re not wrong—they’ve been in the works for a decade and a half. But now is the time that millions of companies need to pay attention.
Publicly held companies adopted the Financial Accounting Standards Board’s (FASB) revamped lease-accounting rules in 2019, and private companies were originally slated to do so in 2020. With one thing and another, notably COVID-19, that was delayed until 2022, which is now less than a year away.
So, what do private companies need to know? Adopting the new rules could be a more time-intensive, resource-consuming effort than you may think, and there are aspects to it you probably haven’t considered–but it’s doable—if you start now.
Here’s some of what you need to know. (This post summarizes a complex set of changes and doesn’t cover every detail. If you have questions about your company’s specific situation, ask MorganFranklin’s technical accounting and financial reporting team.)
If You Enter Into Leases, Your Balance Sheet Will Look Different
Leases are everywhere. Companies pay to lease office space to house their businesses, or lease fleets of vehicles, or office equipment; they incur financial obligations far into the future to do so. Many of those obligations will now have to be added to a company’s balance sheet, as right-of-use assets and liabilities.
That has not always been the case in the past—most leases haven’t been carried on the balance sheet. That means a company’s investors and other stakeholders were not getting a full portrait of the company’s financial condition; some big companies had tens of billions of dollars in lease commitments that weren’t on the balance sheet. The only way a company’s stakeholders knew about these commitments was based on some lease information that had to be disclosed in the footnotes to a company’s financial statements.
The balance sheet will be impacted on both sides: assets reflecting the right to use the leased assets, along with liabilities reflecting the obligations to make lease payments will be recognized. As such, a company’s net worth (its assets minus its liabilities) may not change. The addition of new obligations, however, could make a company look much more leveraged, and common financial ratios could be affected, such as return on assets. On the other end of lease transactions, accounting for “lessors”—those who actually own the assets and are leasing them out—is largely unchanged.
None of This Really Changes a Company’s Economic Reality
The changes notwithstanding, a company is still leveraged to the same extent it always was. The new rules just make it easier for people outside the company to see it, like investors, lenders, and credit-rating agencies. Even before the rule changed, Standard & Poor’s and Moody’s adjusted a company’s numbers to take the estimated impact of leases into account.
Precise Numbers Rather Than Estimates for Stakeholders
Thus far, the new rule is showing that some companies are more leveraged or less leveraged than had been thought. Before the rule changed, the market tended to estimate a company’s future lease obligations at a multiple of six to eight times its annual rent expenses; accounting-research firm Zion Research Group has noted that the actual lease obligations that companies put on their balance sheets under the new rule often fall outside that range.
Software Is Highly Recommended
Achieving compliance with lease-accounting changes on day one is only the beginning for private companies. The big effort is selecting a software that not only allows companies to be compliant in an efficient manner, but also continues to sustain compliance. And, with each company having its own definition of success, identifying a lease-accounting software solution that has the best outcome with little to no manual effort is critical for private companies.
Changing Lease Accounting Carries Its Own Complications
The lease-accounting changes could affect the decisions you make. For instance, if you have to report lease obligations differently, will that change your thinking about whether to lease something or buy it? Short-term or “variable” leases—those where future payments could vary depending on circumstances—those don’t have to go on the balance sheet; does that make it more likely that companies will use those kinds of leases?
Think About the Role COVID-19 Plays
COVID business upheavals have led to lease changes, concessions, and cancellations. For instance, a lot of leases are for retail stores and restaurants that people don’t want to frequent now, and some lessors have agreed to forgive or defer lease payments from companies. Companies must take those modifications into account. Last April, the FASB provided revised guidance to simplify how lease concessions caused by the pandemic should be handled.
Stakeholders Need To Be Informed
While private companies that haven’t yet adopted the rule generally won’t have to worry about disclosing the lease-accounting change to a large number of investors, communicating with stakeholders will still be important. Otherwise, investors might see your reported leverage suddenly spike upwards, and they won’t know why unless you tell them. Don’t wait—get started today!