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New Lease Accounting Standard Requires Capitalizing More Assets

10/2/18 – Andrew Donohoe & Dan Owens

Just when you thought accounting rules couldn’t get more complicated --- especially after the Revenue Recognition changes required for closely-held businesses in 2019 --- the Financial Accounting Standards Board (FASB) has changed how we account for leases beginning in 2020.  Rather than simply expensing operating leases as they are paid --- which is what we do now --- Accounting Standard Update (ASU) 2016-02 Topic 842 mandates that certain assets, along with their lease payments, must be capitalized and shown on the balance sheet, not expensed when paid.  Topic 842 repeals and replaces the current lease standard, FASB 13, which has been in place since 1976. 

FASB 13

FASB 13 (Topic 840) requires capitalizing lease payments today only if one of the following four conditions exists:

  1. The title changes hand at the end of the lease;
  2. There is a bargain purchase option (like $1) at the end of the lease;
  3. The lease term is > 75% of useful life of the leased assets; or
  4. The lease payments are > 90% of the Net Present Value (NPV) of the leased assets.

Topic 842

Beginning in 2020, companies must capitalize leased assets and related lease obligations if:

  1. The lease term is > one year, or
  2. There are “Evergreen” leases for terms < one year

An “Evergreen” lease exists when the lessee expects to renew a lease of < one year in duration.  Examples include related party leases and leases where the lessee has expended significant funds on leasehold improvements and is unlikely to leave at the end of the year.

Why the change?

The FASB had been considering doing something with operating leases for many years, and showing the future operating lease payments as a balance sheet liability, rather than just a footnote, highlights its presence to the financial statement readers.  Some financial statement users often ignore lease obligations and can do so to their detriment --- such as with Enron, which had numerous off-balance sheet obligations that contributed to its failure.

Balance Sheet Impact

In capitalizing the lease obligations and leased assets, the company creates either:

  1. A Financing Lease Liability for the purchase of an asset that is consumed over the lease term (equipment), or
  2. An Operating Lease Liability for assets that are not consumed over the lease term (land, buildings). 

These two kinds of lease liabilities will be equal to the net present value (NPV) of the lease payments and will be reported separately on the balance sheet.  In addition, the current portion of these lease liabilities will be shown under current liabilities, and the long-term portion (> one year) under long-term liabilities.

As for the leased assets, a “Right of Use” (ROU) asset, also equal to the NPV of the lease payments, gets capitalized onto the balance sheet.  These assets will be shown as part of property and equipment or other assets and be amortized over the life of the lease, but the current portion of the amortization will NOT be moved to current assets. 

Banking and Bonding Impact

For contractors, this capitalization of what was formerly expensed when paid creates two new situations for the contractor’s balance sheet:

  1. The debt-to-equity ratio will increase, and
  2. Working capital (current assets less current liabilities) will decrease.

For both banking and bonding purposes, contractors’ debt-to-equity ratios are important factors that bankers and sureties consider before granting loans or providing bonds to the contractor.  Therefore, the metrics that the banks and surety use must change, or they will need to remove the Topic 842 Lease changes from their contractor clients’ balance sheets and make their loan and bonding decisions using the same metrics they use now.  Sureties, in particular, track such metrics over time, so their transition to new metrics may not happen right away.  However, rather than continually having to make such changes to their contractors’ balance sheets in future years, sureties may develop new metrics once they see how their clients --- both with and without such leases --- perform over time.

Statement of Income Impact

As the asset and the liability are used and paid, their treatment on the Statement of Income will depend upon which type of lease they represent --- financing or operating.  For financing leases, interest expense on the lease liability and amortization of the leased asset will be presented similar to how they are presented now for leases capitalized under FASB 13.  For operating leases, the “interest” portion of the operating lease liability payment will be combined with the amortization of the ROU operating leased asset. It will be shown as operating lease expense in continuing operations, similar to how operating leases are shown today.

Other guidance

The lease renewal option is another factor to consider. Many leases, especially those for “unconsumed” assets (land, buildings), often have renewal options.  In these cases, if the lessee is “reasonably certain” (defined as a probability of 75-80%) that the lease will be renewed, then those renewal option(s) must also be capitalized.

Finally, there is also guidance for when a lease does or does not exist, as well as what assets are exempt from this standard.  For instance, leases to explore for minerals, oil, natural gas, or similar non-regenerative resources; intangible assets; assets under construction; or biological assets (including timber); do not get capitalized.

Implementing the new Lease Standard

If you have a comprehensive listing of all of your operating leases now (which you need anyway for current financial statement disclosures), then you already have the building blocks for creating the new ROU Assets and Lease Obligations.  Once 2020 begins to draw near, your outside CPA can help you assess and calculate which leases must or may not need to be capitalized.  In the meantime, you should be disclosing this pending change in your annual financial statements.  Please contact us if you have any questions.