by Brandon Yip — This article originally appeared in the September/October 2018 issue of FMJ.
On February 25, 2016, the Financial Accounting Standards Board (FASB) issued a new lease standard, ASU 2016-02, which requires lessees to record the assets and liabilities of all leases, including operating leases, on its balance sheet.
The new guidance is effective for public companies with annual periods after December 15, 2018 (calendar periods beginning after January 1, 2019). For private companies, and all other entities, it is effective for annual periods after December 15, 2019 (calendar periods beginning on January 1, 2020). Early adoption is permitted for all entities regardless of whether such entities elect to adopt the new revenue standard.
The assets of a lease represent a “right to use” of a lease property while the liabilities represent the lease payments. Leased property can include, but is not limited to, facility spaces, warehouse machinery and office equipment. Lessees can make a policy decision to exclude any short-term leases with a period of twelve months or less from its balance sheet. There is no balance sheet impact under the current operating lease accounting guidance. Instead, lessees include a disclosure in the footnotes to their financial statements. Additionally, as the new lease amendment is adopted, existing leases are not exempt and will also need to come on to the balance sheet.
In analyzing their leases, lessees will determine if their leases are classified as a finance or operating lease. Financing leases use similar criteria to current accounting guidance for capital leases. Leases that do not fall under the finance lease guidance will be classified as operating leases. Finance lease accounting will include an interest expense component leading to a larger liability compared to the operating leases. The lease liabilities will typically be repaid on a straight-lined basis over the lease term.
Lessors will also see an impact in how they account for leases, though not as robust as lessees. The new changes mainly help align the lessor accounting with the new revenue recognition standards that became effective in 2018 for public companies. Lessors will continue to assess whether their lease qualifies as a sales-type lease, direct financing or operating. Accounting for these leases remains similar under the current and new guidance. For leases to qualify as a sales-type lease, the agreement must meet the criteria of a sale under the new revenue recognition guidance. Leases that do not meet the criteria will be accounted for as either a direct financing lease or operating lease.
For many facility managers, they end up taking on the role of both lessor and lessee. As lessors, they may manage properties with vacant units or units with expiring leases and it is their responsibility to find new tenants to lease them. As lessees, they may enter into agreements to lease equipment necessary for building operations. The new lease standard is not just a challenge for a company’s accounting team. The challenge includes anyone involved in the leasing process, especially facility managers.
On the lessor side, facility managers will need to be prepared to deal with how tenants may want to structure their leases. While the accounting standards won’t impact lessors as greatly, as discussed above, the changes will have an impact on new tenants and how they may operate. Some companies report earnings to investors on a metric known as EBITDA (earnings before interest, taxes, depreciation and amortization). As such, they may find it more beneficial to classify their lease as a finance lease versus an operating lease since part of the lease expense on a finance lease relates to interest expense. Some companies could look to structure their current or future lease to qualify as a finance lease.
On the other hand, with the addition of new lease liabilities on a company’s balance sheet, it could represent a significant increase in the company’s overall liabilities and lead to challenges like potentially impacting the company’s ability to borrow from lenders. Companies looking to be acquired may also be hesitant putting such a large liability on their balance sheet. The lease liabilities could also impact certain debt covenants on existing debt. As a result, lessors will also need to be prepared to discuss any potential lease amendment requests from existing tenants so they can meet any debt covenant requirements they may have. Future tenants could look to new ways to structure leases to avoid putting the lease liabilities on their balance sheet, including opting to enter into a shorter lease period. With the rise of shared workspaces where companies or individuals can rent space on a short-term monthly basis, some companies may look to see if that is a viable option to avoid putting the leases on the balance sheet. Facility managers may look to see if that is a viable option to meet the needs of its existing and future tenants. As further guidance comes out, it remains to be seen if the FASB will determine if these shared workspace arrangements should fall under the new lease guidance.
On the lessee side, facility managers will face many challenges when it comes to implementing the new lease standard. While the accounting department will be mostly responsible for implementing the new lease standard, facility managers should have an understanding of the changes, so they are prepared for any policy or process changes once the standard is adopted.
Accounting departments may look to their facility mangers to identify all leases the facility has entered into to ensure completeness of the accounting records as the accounting department adopts and implements the new lease standard. These leases can include anything from office equipment like copy machines to building generators to vehicles. Facility managers may want to start the process now of identifying all leases and ensure copies of the leases and amendments are readily available. It can be a painful process to track down a missing lease during the implementation period. Going forward, facility managers may also need to discuss internally whether it makes sense for their company to lease equipment or buy it out right to avoid putting certain liabilities on the balance sheet for reasons discussed above.
Facility managers may need to assess their lease database and how leases are maintained. Many companies use spreadsheets to track and manage their leases. While spreadsheets can be easy to use, they are also more prone to errors, especially if a company has multiple lease arrangements spread across various subsidiaries. Spreadsheets are often accessible by anyone and there are few controls to minimize input errors. Companies with multiple leases may want look into lease software that help track, manage and analyze leases. Many of these lease software solutions are also compatible with a company’s existing accounting software, making implementation smoother. If companies do decide to migrate towards lease software, facility managers should get involved in the process of choosing a lease software as they may be involved in updating and maintaining the new database after adoption of the standard.
The effective date for this new pronouncement is just around the corner and companies should begin the process of planning how it will it will implement the new standard and analyze its leases, especially for those companies with multiple lease agreements. Facility managers should take the time to read through the appropriate literature to ensure they have an adequate understanding of the new standard. Additionally, facility managers should start the conversation now with their accounting departments to discuss what is needed from their end to assist in the implementation of the new lease standard. It should also be discussed early on in the planning process if there is a need for third party consultants to assist in any part of the implementation process, whether it is assisting in the setup of new software or developing new policies and procedures. If the need for third party consultants is deemed necessary, it can be cost effective to involve them earlier in process as opposed to a few months before adoption is required. Additionally, looking for consultants early on gives companies the advantage of comparative shopping. Adoption of the new lease standard isn’t just knowing what accounting rules are changing. It’s also ensuring that the Company is prepared to analyze and record its leases in accordance with the new lease standard on the date of adoption and going forward.
If the implementation of a new revenue recognition standard has taught us anything, companies that adopt new accounting guidance must plan on a timeline with the expectation that there will be some bumps along the way. Companies should reach out to an external consultant if needed to ensure the company is prepared when the standard becomes effective. Many times, companies underestimate the amount of time and manpower, as well as the cost it takes to implement a new accounting standard.
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Brandon Yip is a manager, assurance and advisory services, at OUM & Co. LLP, a CPA firm with offices in San Francisco and San Diego County. He can be reached at byip@oumcpa.com.