A new accounting standard for leases was issued by the Financial Accounting Standards Board (FASB) earlier this year to provide greater transparency and information to investors and creditors. This long-awaited change aims to prevent companies from obscuring the real extent of their financial obligation, a practice that has led to a lack of confidence in financial reporting.
The change recognizes a shift in focus with regard to leases. Under current standards, operating leases are off balance sheet items covered only in the footnotes to the financial statements. Going forward, all leases for real and personal property must be disclosed on the balance sheet as assets and liabilities, although lease commitments will be considered non-debt liabilities.
The new standard affects all types of leases, including real estate, machinery, computer technology and equipment used for manufacturing and transportation. The companies most affected by the new rules include large, publicly traded companies; transportation companies with equipment leases for airplanes, trucks, trains and ships; and retail operations such as drugstore chains and banks with branch offices.
FASB estimates that U.S. public companies will add more than $1 trillion to the liabilities section of their balance sheets under the new standard.[i] With individual company lease commitments ranging from a few million to tens of billions of dollars, the new standard can significantly alter a company’s balance sheet. The change will make many companies appear larger if they have many leases, despite no related change in their equity.
The new rule will go into effect for U.S. public companies beginning after Dec. 15, 2018. For all other companies, the standard will be effective for fiscal years beginning after Dec. 15, 2019, and for interim periods within fiscal years beginning after Dec. 15, 2020.
It’s important for companies to start their transition to the new rules early, as they will need to review all their leases, capture pertinent data, test accounting systems and ensure accurate reporting. Although the new standard doesn’t go into effect for a few years, companies will be required to provide investors and regulators with two to three years of past financial statements for comparisons.
The lender’s point of view
Companies may wonder if the new lease accounting standard will change how they are viewed by banks and lenders when they seek lease financing. The answer: The accounting standard change should have little or no impact on the evaluation of a company’s creditworthiness. Lenders and credit rating agencies have long factored in the information contained in financial statement footnotes and other off balance sheet items when they perform financial analyses.
Other than the return on assets ratio, most financial ratios and measures will remain unchanged, and FASB believes most companies will not experience any significant negative impact from this change. The new lease accounting standard should have little or no impact on most companies’ debt ratios, debt covenants or credit ratings.
Lease-versus-buy decisions based on company needs
Many factors affect a company’s decision about whether to lease or buy equipment, including capital needs, tax benefits, service, asset management, cash flow savings, asset disposition and risk management. Most companies will want to retain the flexibility to decide the lease-versus-buy question according to what best aligns with their business strategies.
Although the new lease accounting standard will have minimal effect on debt covenants, it’s wise to review the standard, along with pro forma financial statements, with your bank or creditors during the transition period to ascertain any potential implications. Most lenders already take into account leasing obligations in their financial analyses, but it’s wise to check if your company may be required to meet different criteria when seeking future leases and loans.
Your accountant can provide you with expertise and advice on how to present your financial statements under the new standard. Working together with your accountant and banker, you can assess the potential impact of lease accounting changes on your balance sheet, run scenarios on your financial statements, and gauge any potential impact on your current and future leasing needs.
Contact our Equipment Financing team for more information on our wide variety of equipment leases including airplanes, truck/automobile fleets, furniture, office and medical equipment and more.