Lease Accounting Impact to Banking and Bonding Capacity
Thinking you have heard about changes to lease accounting more than two years ago and questioning if this article is relevant to you? I don’t blame you, but the answer to both questions is “yes”. A new accounting standard was published in 2016 and if you have any type of leasing arrangement, there will be changes to financial reporting.
Guidance under Accounting Standards Codification (ASC) 842 replaces the previous standard that has been in place for nearly 40 years. All financial statement users should begin understanding what changes to expect and all businesses with leasing arrangements should begin forming an action plan to implement the changes.
Why is there a new standard for lease accounting in the first place? Almost all businesses have lease arrangements. These leases could include a copier, rental of corporate headquarters or warehouse, and equipment. From administration activities to production, leasing arrangements are instrumental in doing business. Under the previous standard, leases were accounted for as capital leases or operating leases. A capital lease would require a company to record an obligation for the lease payments that would be due and similarly an asset that they would amortize over the period of the lease. Operating leases only required a company to record the annual lease expense and disclose the future obligation. While obligations related to operating leases were disclosed, they were not reflected in the balance sheet as an asset and liability despite the fact that the leasing arrangement may be critical to the business’s ongoing operation and represent a significant obligation of the company.
Start to prepare by knowing the implementation dates: public companies – years beginning after December 15, 2018; and private companies – years beginning after December 15, 2019. Still more than a year out for private companies, but now is the time to work with your advisors or in-house accountants to make sure you are ready for implementation and have prepared the users of your financial statements.
From the perspective of the lessee, the leasing standard will classify leases as a finance lease or operating lease, which isn’t all that different, except that both the finance and operating leases will be reflected as assets and liabilities on the balance sheet under the new standard.
What does that mean for a company’s financial statements?
- Balance sheets are grossed up to reflect a lease asset and lease obligation.
- Debt to Equity Ratio increases because of the lease obligation recorded.
- Working capital and current ratios are negatively impacted by the current portion of the lease obligation.
- Financial statement disclosures are expanded.
The example to the right demonstrates how major the changes in bullets one through three could look for a company. The example presents pre and post implementation for a contractor that has a lease for its corporate headquarters ($200/month for 10 years; beginning year of implementation; discounting payments has not been taken into consideration to simplify the example).
Facility leases will likely have the biggest impact to a company, but further consideration will have to be given for a company’s other leasing arrangements including equipment and vehicles.
Current lease disclosures do not provide enough detail to financial statement users to evaluate the full impact of implementing the new guidance. Individual companies must be proactive in determining the impact to its financial statements and communicating that impact with banks, bonding companies, and other users of the financial statements.
Financial statement covenants in borrowing facilities may need to be modified and a company should determine if its bonding capacity is going to be impacted. Companies performing work for the Department of Transportation (DOT) should also be monitoring their prequalification capacity as any impact to working capital may be exacerbated by how capacity is calculated (i.e. Indiana DOT applies a 10 X factor to working capital).
The following paragraphs go into the technical application of the new lease standard including classification of leases and providing examples of how the different leases will be recorded. While not comprehensive, this will provide a base-line for your accounting team to begin analyzing the impact.
The new lease standard classifies leases that transfer control of the underlying asset as finance leases while other leases will be classified as operating leases and only transfer control of the use of the underlying asset.
Transferring control of an underling asset is satisfied by evaluating criteria that are similar to the previous lease guidance. These five criteria include:
- Transfer of ownership of the leased asset.
- Option to purchase the leased asset that is reasonably certain of being exercised.
- Lease term is a majority of the economic life of the asset.
- Present value of lease payments and any guaranteed residual value is greater than the asset’s fair value.
- The leased asset is unique and there will be no alternative use at the end of the lease term.
Leases not meeting these criteria would be only transferring control of the use of the underlying asset and classified as operating leases.
The new leasing standard in conjunction with the revenue recognition standard does provide for other considerations that should be researched and evaluated as appropriate when classifying a company’s leases including variable payments, penalties, and fees paid in structuring the lease. Certain payments associated with a lease may be excluded if it provides a separate good or benefit.
A finance lease will be recorded similar to the capital lease of the past. Recognition of an asset and liability for which the value is determined based on the discounted underlying lease payments at a borrowing rate commensurate with the average borrowing rate available to the company if not specified by the lease agreement. Monthly payments would include principal against the lease obligation and interest expense. Depreciation or amortization expense would also be recorded over the life of the asset or lease term. Annual expense under a finance lease decreases over the life of the lease as more of the monthly payment will be applied toward principal versus interest expense.
An operating lease is recorded by also recognizing an asset and liability for which the value is determined based on the discounted underlying lease payments. The main difference from a finance lease is the expense is reported as lease expense versus interest expense and depreciation/amortization. This difference in reporting will impact your EBITDA since finance leases will be addbacks to earnings and operating leases will not.
If you are an accountant reading this article, you have probably questioned how to record the journal entry. Below is an example of an operating lease of a facility over five years, for annual payments of $10,000 per year at the end of the year, and assumed interest as presented in the table (for ease in calculating).
The annual lease expense will total the sum of the columns with an asterisk and equal $10,000 each year.
Finally, how does this information reach the income statement and statement of cash flows?
Finance leases will be recorded on the income statement in a similar manner as to other interest expense and depreciation/amortization items. Operating leases will recognize lease expense (the sum of the interest and amortization to arrive at straight-line lease expense) as a component of cost of sales or general and administrative expense based on the nature of the underlying asset.
Statement of Cash Flows
Finance leases will include the cash payment representing the principal portion of the lease liability as a financing activity. The interest portion of the payment will be included as an operating activity (represented in your net income from the income statement). Depreciation/Amortization will be included as an add-back to operating activities similar to other depreciable assets.
Operating leases will include cash payments (straight-line lease expense) as an operating activity included in your net income from the income statement. The recognition of a lease asset and liability, and the amortization of the lease asset and servicing of a lease liability will be presented as non-cash investing and financing activities.
A company must be proactive in evaluating its leasing arrangements and determine how to approach implementation. The administrative burden of adhering to the new lease standard will depend on the extent of leasing activities and be unique to every company. Implementing the new standard provides an opportunity to revisit the company’s procedures for aggregating information on lease commitments and how the flow of information reaches the accounting department to ensure it is properly recorded. Consult with your accounting advisor on best practices to aggregate information in addition to determining what the impact to the company may be in order to proactively consult with banking and bonding companies.