No matter the size of your company or its type, prepare for a financial statement impact! The reason is the new lease accounting standard (ASU 2016-02). If you lease anything as part of your business, it is time to pay attention! Recognition changes are here, and it may alter your company’s financial perception in the eyes of shareholders, investors or the IRS. It may be good or it may be painful; depends on how your CFO views it all. Let us get into the details.
Understanding the Change
The new standard changes recognition of leases on your balance sheet. Two types of leases, capital, and operating leases go under the microscope with ASU 2016-02.
With the change, all lease types need recognition on the balance sheet. The big difference hones in on operating lease recognition.
Key Dates of the Standard
The entity for United States accounting standards, the Financial Accounting Standards Board (FASB), made a lease accounting change in 2016. The new standard goes into effect for all public companies with an annual period beginning December 15, 2018. For any entity not public, the change is effective for annual periods after December 15, 2019. For example, a public entity would have to comply starting in the calendar year January 1, 2019, while a non-public entity can wait until January 1, 2020. Early compliance is also acceptable.
Breaking Down Operating and Capital Lease Types
While leasing workplaces for your team may seem like a relatively straight forward process, the accounting and tax treatment of these leases can vary greatly depending on if a lease is considered to be capital or operating in nature.
You may already be familiar with the two common types of leases, capital, and operating leases. A capital lease is a mechanism where you take on debt to own the asset. An example would be your home and its mortgage. You pay the mortgage until you own the house.
Operating leases are different in that you never own the asset. You are paying as a lessee for your right to use the asset. If you rent a home instead of buying it, that is an example of an operating lease. In the business world, most common operating leases include rental of office space.
Both types have benefits and advantages and, depending on the nature of the assets, a company can benefit from holding capital or operating leases. It’s important to note, however, that operating leases are changing with regards to accounting rules as both the U.S. and International accounting regulators are looking to treat all leases as capital in nature.
Recognizing Operating Leases Under the New Standard
Before the lease accounting standard change, only capital leases need balance sheet recognition. This is no longer the case with the standards change! Operating leases did not need inclusion on the balance sheet. You would only notice a rental expense as part of your income statement, and that’s it!
With the new standard, operating leases need balance sheet recognition. The new accounting standard requires operating leases to have both an asset, and a liability recorded on the balance sheet.
Say you rent office space. An operating lease will now show as an asset (the lease value) and a liability (the remaining lease payments). The income statement will include an expense to balance the asset and liability.
Companies Need to Take Notice
As you wrap up 2018 and look at your operations and facilities and real estate footprint, understanding this change is key. Before the change, you could rent office spaces in various cities and all would be a text footnote on your financial statements, not a part of your balance sheet. This could make it look as though you had far less debt than was the reality.
The change now requires balance sheet recognition for operating leases. There is no more hiding the lease debt! Businesses will no longer find it as appealing to have rented office space. Businesses who are closely watching the amount on their balance sheet that represents their liabilities may find it less appealing to have office space contracts (aka leases) on the books than in the past; others may be fine with the liability amount increasing.
Even signing a 12 month agreement to rent space in a coworking facility may be viewed as a “liability.” Ask your accounting gurus in house or outside counsel as to what the 2019 perspective on this should be for your firm. No matter what you find, if you are like many other companies we talk to, you are now looking for creative solutions and fast. A simple way to use coworking and shared offices without signing a lease is feasible via license of the proprietary software behind the Upflex app; and treating the fee as a pure play expense allows for instant office space only when needed, without a long-term lease and the financial implications resulting from FASB.
The new lease accounting standard is arriving at a rapid pace, and with it brings changes requiring immediate action. The appeal to reduce balance sheet liabilities that were once out of sight will increase. A trend in the direction of lowering operating leases is likely. Also, the need to ensure the existing operating leases are reported on the balance sheet to follow the new FASB standard becomes imperative. Start your preparation today before the effective date arrives!