There will be significant changes in the way your company accounts and reports leases on your financial statements. The technical term is ASU No. 2016-02, Leases. The effective date for private companies to implement the change is for fiscal years beginning after December 15, 2019. Although that date may seem far into the future, the changes it brings are significant to the balance sheet and could have a negative impact on your loan covenants
Currently leases are reported as either capital or operating leases. Capital leases treat leased property as though it was acquired meaning the property appears on the balance sheet as an asset along with the associated lease debt presented in current and long term liabilities. The capital lease asset is amortized over its life and the debt is reduced by cash payments against the liability balance with a recognition of interest expense. The presentation of this type of lease will remain relatively the same. The terminology changes from Capital lease to Right-of-Use Asset Finance Lease. The criteria is mostly unchanged as to which leases are categorized to this type of lease so there is very little actual change in reporting to be recognized.
The current operating lease treats lease (rent) payments as an expense directly to the income statement without any recognition of the leased property on the balance sheet. Only if there are notes to the financial statement will the reader of the financial statement be aware that there is a long-term liability associated with this type of lease.
Under the new rules, an Operating Lease will now be called Right-of Use Asset Operating Lease and an asset and liability will be presented on the balance sheet. Basically this recognition will apply to any lease that has a term great than one year and is not treated as a Right-of-Use Asset Finance Lease.
There will be no real effect on the income or cash flow statements of the financial statements but there will be real changes on the balance sheets. There will be real changes as well to loan covenant calculations. Debt-to-equity ratios increases, return of assets, current ratio and interest coverage ratios decreases. EBITDA may increase as previous operating leases may become a capital/financing lease.
It is important to understand the changes in lease reporting early and the effects it may have on financial statement covenants. This will prevent covenants from potentially failing when the new standard becomes effective. Review of this standard should be done with your lenders and CPAs so changes to finance agreements can be made prior to the effective implementation dates.
Wayne L. Martin, CPA, CGMA