Though we have known it was coming for awhile now, ASU No. 2016-02, Leases (Topic 842), the new lease accounting standard, is here. Hopefully, you have had a chance to prepare for the need to capitalize all leases or have a plan to do so before 2019.
As with virtually all new accounting standards, companies need to perform a lot of work between now and the standard’s effective date (2019 for public companies and 2020 for everyone else). Lease agreements will need to be collected, read, and analyzed, and a determination will need to be made as to whether these agreements are Finance leases (the former capital leases under the old lease accounting guidance) or Operating leases (analogous to operating leases under the old guidance).
Further, companies will need to review the terms of the leases, any modifications, their cash flows, and other pertinent information in order to determine the accounting effect of adopting this significant standard. Depending on the size of your operations, the amount of resources available to assist with this task, and the complexity of the lease agreements, these chores will likely take a good chunk of time. Between these efforts and adopting the new revenue recognition standard over this same time period, the next few years will be busy. However, there may be equally large, or even greater, impacts to businesses from the new standard than merely recording leased assets and their related liabilities on the balance sheet.
Here are 10 items for consideration as you plan to adopt the new standard:
- How will implementing the standard impact your debt covenants and other contractual arrangements? As many leases were not previously capitalized by lessees, the impact of capitalizing these leases may not have been considered in many common covenant ratios found in debt agreements. For instance, the standard will result in more debt being recorded on the balance sheet, which will impact debt-to-equity or other debt ratios. Further, recording the current portion of an operating lease liability as a current liability may impact the calculation of a company’s liquidity ratios. Lastly, under the new standard, additional interest expense may be recorded compared with interest expense under the old lease guidance. This may impact interest coverage or other ratios that include interest expense as a component.
- Debt covenants often contain other common restrictions, such as limitations on new debt, limitations on capital purchases, and debt subordination clauses. Will the newly recorded lease liability impact those debt limitations, and will the right-of-use assets count against capital asset purchase restrictions? Is the lease debt subordinate to other company debt? These questions have potentially large implications for debt covenant compliance, especially for leases of longer durations.
- Many debt agreements have operating cash flow and/or earnings before interest, taxes, depreciation, and amortization (EBITDA) targets that were drafted under the old lease accounting rules, when classification of leases as either capital or operating followed more bright lines as opposed to the more principles-based guidance in the new standard. Analysis of lease terms and conditions under the guidance of the new standard could result in different classification of a lease as either Finance or Operating than under the old standard. The application of the recognition and transition guidance could result in different amounts being recognized as lease expense and in a potentially different location of such costs in the financial statements.
- As there is no GAAP definition of EBITDA, companies often define it in different ways, frequently making adjustments to items that are part of GAAP financial statements. For debt covenant compliance purposes, companies and lenders frequently make adjustments to EBITDA for company-unique or one-off items, such as restructurings or payments of certain types of debt principle and interest or other expenses. The inclusion of additional amortization expense related to the right-of-use assets, as well as the location of payments of principal and interest on leased assets in the statement of cash flows, may create ambiguity about or even change the calculation of EBITDA. This may potentially impact debt covenant ratios and compliance calculations.
- Beyond debt covenant compliance issues, there are other operational considerations for companies to assess when implementing the new lease standard, such as corporate governance. Companies frequently have approval thresholds for capital assets based on the amount of the expenditure. Leased assets financed through operating leases and their related debt, which would not have wound up on the balance sheet under the previous accounting guidance, may not have been subjected to this approval process, especially if no debt was being recorded. However, it now may be necessary to reconsider the review and approval process for these types of long-term commitments, especially if the capitalization of leases and recording of the related debt do have an impact on a company’s debt covenant compliance or other contractual obligations. This inclusion may trigger further review of all the approval thresholds, as it is likely that many more capital commitments will be subject to such a review.
- Forecasting and strategic planning documents may need to be adjusted to conform to the financial statement treatment of leased assets and liabilities.
- If these leases are to be subject to review procedures, what thresholds should companies use? Does the inclusion of leased assets in this approval process affect internal rate of return or cost of capital calculations used to support capital purchases? Are these thresholds appropriate, given the types of assets being leased and the term of these leased assets? Do companies need to devise new approval processes to support the approval of entering into lease agreements?
- In public companies, how will implementation of the new lease accounting guidance impact the earnings and other guidance provided to the investing community? How is this impact communicated? Clearly, there is a role for the investor relations team in crafting this message.
- You won’t know the answers to questions unless you start asking them. While a company’s accounting department is likely to head up the implementation and adoption effort of the new standard, it is not enough to include just that group. The best implementation plan incorporates review and insight from all of the potentially affected departments. In addition to involving accounting, consider including the following departments:
- Finance. Company treasury personnel review the proposed accounting transition to determine what, if any, impact the adoption will have on debt covenants or other financial agreements.
- Legal. A company’s legal department should get involved early to assist with this assessment, as well as review any proposed changes to standard lease agreements that either a lessee or lessor may propose to mitigate the impact of adopting the standard.
- Sales. From the lessor’s perspective, representatives from the sales department should be consulted to assess the commercial impact of any proposed changes to contractual language.
- Human Resources. Consider having this department determine if these changes could affect compensation plans.
- Procurement. This department should be involved in the review to provide its perspective on any proposed changes to agreements and add to the cost/benefit analysis.
- If you think that debt covenants or other agreements will be impacted by adopting the new standard, reach out to the affected parties as soon as possible. Banks and other financiers are likely to get swamped with questions as the adoption date nears. Getting on their agenda first, with proposed changes to agreements in hand, will likely aid the process of amending the contracts as needed or clearing up any uncertainty, and help prevent getting caught up in a cookie-cutter approach banks may take as the date of implementation gets closer.
Many companies may underestimate the operational impact of adopting Topic 842. Don’t be one of those companies. Be proactive in identifying all potential impacts and start conversations with the affected parties early to ensure that concerns are being addressed on the terms most advantageous for your company.
For a thorough, one-stop shop for what you need to know about Topic 842, attend Surgent’s live webinar with Rich Daisley.
Rich Daisley is Senior Director, Accounting and Financial Reporting Content for Surgent Professional Education. With over 26 years of experience in the accounting and auditing field, Mr. Daisley has worked in both the client service setting, mainly for PwC’s Capital Markets and Accounting Advisory Services Group and for PECO Energy’s Merger and Acquisition Group, and in the internal capacity setting as a course developer and facilitator creating leading training courses for PwC and Surgent. Rich lives in suburban Philadelphia.