After repeated postponements by the Financial Accounting Standards Board (FASB), the new lease accounting standard is finally set to take effect for private companies for fiscal years beginning after December 15, 2021 (2022 for calendar year-end companies). Found in Accounting Standards Codification (ASC) 842, the new standard applies to all businesses that report their financial results in accordance with U.S. Generally Accepted Accounting Principles (GAAP). Although ASC 842 will require lessors to make some changes to the way they report leases on their financial statements, its biggest impact will be felt by lessees, particularly those with leases that are currently classified as operating leases.
Impact on Balance Sheet
The new standard generally preserves the distinction between operating leases — which give the lessee the right to use the leased asset during the term — and capital or “finance” leases — which transfer ownership of the asset to the lessee at the end of the term. However, unlike the current standard, which allows operating leases to be treated as off-balance-sheet transactions, the new standard will require lessees to record all leases with terms greater than 12 months on their balance sheets.
When the new standard takes effect, lessees will record a “right-of-use” asset, which represents their right to use the leased asset for a period of time. They will also record a corresponding liability equal to the present value of the lease payments. Notably, the new standard classifies operating lease liabilities as “operating liabilities” rather than lumping them together with finance lease liabilities and other “debt.”
Related Read: Topic 842 Basics for Lessees
Impact on Loan Covenants
Lessees should evaluate the potential impact of the new standard on their loan covenants with banks and other lenders. FASB’s intent in classifying operating lease liabilities separately from traditional balance-sheet debt is to minimize the standard’s impact on borrowers, whose loan covenants may require them to maintain a certain debt-to-equity ratio or level of debt service coverage. However, depending on how a loan agreement defines “debt,” the addition of new liabilities to the balance sheet may cause some borrowers to violate these covenants. Similarly, the new standard may cause violations of covenants tied to liquidity measures, such as the ratio of current assets to current liabilities.
Changes in the way operating leases are presented in the financial statements do not affect a company’s cash flow, so most lenders will be willing to adjust their loan covenants accordingly. But it is important for borrowers to discuss the potential impact with their lenders before they implement the new standard to avoid technical violations of their covenants.
Treatment of short-term leases
As noted above, the new standard requires lessees to record all leases with terms greater than 12 months on their balance sheets. However, they may elect not to record leases with terms of 12 months or less, but this does not mean that a lessee can keep leases off its balance sheet by using a 12-month term. For purposes of the new standard, a lease’s term includes the initial noncancelable period, plus any renewal options that the lessee is reasonably certain to exercise, considering all relevant economic incentives (e.g., investments in leasehold improvements, costs of relocating, etc.).
In addition to evaluating the new lease accounting standard’s impact on their financial statements, companies should also make sure they have systems and processes in place to track and report their leasing activities.
To discuss how the new lease accounting standard will affect your business, please contact Stephanie Zaleski-Braatz at [email protected] or 312.670.7444. Visit ORBA.com to learn more about our Real Estate Group.