After years of deliberation, in February 2016 the Financial Accounting Standards Board (“FASB”) issued ASU 2016-2 – Leases (Topic 842) – that will change the accounting and reporting of leasing activities for nearly all entities that issue financial statements prepared in conformity with U.S. GAAP. The main focus of the new guidance is on lessees’ accounting and reporting for leases, and recognition of a lease asset, the right of use (“ROU”) asset, and a lease liability in the statement of financial position. While the income statement recognition will not significantly change under the new guidance, the recognition of ROU assets and lease liabilities may have a major impact on an entity’s financial ratios used by its lenders in financing arrangements. Understanding, and communicating, the impact on the financial statements and related financial covenants to lenders will be important to the entity’s financing and operations.
The FASB’s stated goal was to “… increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements.”
In very summary form, for lessees the guidance requires:
- For all lease contracts (other than short term leases) the present value of the stream of lease payments will need to be recognized as a lease liability and a right of use (“ROU”) asset (with certain adjustments) on the balance The income statement recognition will depend upon the type of lease involved.
- For operating lease contracts (most property leases), an expense will be recognized in the income statement as the sum of the interest on the lease liability plus amortization of the ROU asset as a single lease cost in the income Amortization of the ROU asset will be the difference between the periodic lease cost and the interest on the lease liability.
- For finance lease contracts (most equipment and other property leases), the income statement will recognize depreciation/amortization of the ROU asset and interest expense on the lease liability consistently with similar costs related to similar assets.
Implementation of this guidance will likely require significant effort. All existing lease contracts must be inventoried, evaluated to determine how they each will be accounted for, and assessed for the overall impact on financial statements and financial covenants, etc. Communication with lenders about the financial impact and related financial covenants will likely also be necessary.
The evaluation will require analysis of all lease contracts (both existing and new) to determine the lease classification and term, to separate the lease component from any nonlease components, and to allocate the consideration to the lease and nonlease components based upon relative standalone prices observed in the market. Payments that are reimbursements of costs of the lessor are not components of the lease and will not be allocated any consideration.
In general, for non-public companies, the guidance is effective for fiscal years beginning after December 15, 2019, and interim periods within fiscal years beginning after December 15, 2020. Transitional guidance requires recognition and measurement of the leases at the beginning of the earliest period presented using a modified retrospective approach.
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