The Financial Accounting Standards Board (FASB) identified leases as an item of concern on financial statements. Until recently, companies were not required to report most leases on their balance sheet which resulted in “off-balance sheet financing.” The long-term nature of leases and their use as a financing tool meant that companies have long-term commitments (liabilities), often costing tens of thousands of dollars, and lasting several years, that escaped clear reporting to investors and creditors.
Some background on GAAP, IASB, and leases
The new FASB rules (ASC 842) took effect for reporting periods after December 15, 2018, for all public companies and go into effect December 16, 2019 for all non-public companies. The new IASB rules (IFRS16) took effect for reporting periods beginning on or after January 1, 2019 for all public or non-public companies.
Effective Date of New Rules
Most leases must now be presented at the present value (PV) and show all future payment as assets and liabilities on the balance sheet. The asset may be the item itself or the right to use the asset. The FASB and IASB parted ways on the treatment of leases. The IASB chose to treat almost all leases as capital leases while the FASB decided on a dual approach.
The FASB’s approach resulted in two types of leases – much like before, but with new names. Type A leases (“financing leases” previously called “capital leases”) require a lease asset and lease liability on the balance sheet, with depreciation and interest expense (instead of rent expense) on the income statement. Type B leases (“operating leases”) require a lease asset and lease liability for the present value of the lease payments on the balance sheet. Amortization of the asset and liability will be combined as one rent expense, not depreciation and interest (good news for government contractors).
You will have to record a Type A (“financing” or “capital”) lease if your current lease meets one of the following criteria:
1. The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
2. The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.
3. The lease term is for the major part of the remaining economic life of the underlying asset.
4. The present value of the sum of lease payments and any residual value guaranteed by the lessee equals or exceeds substantially all of the fair value of the underlying asset.
5. The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.
New FASB & IASB Rules for Leases
Many operating leases were treated as period expenses on income statements and never presented on balance sheets.
For example: Company A leases a building for $5,000/month and would show $60,000 in rent expense on the income statement each year. Company B decided to buy the same building would show an asset (building) and a liability (mortgage) on their financial statements. Assuming many commercial building leases last five or more years, a user of the financial statements may not know that Company A had a liability of $300,000 or more.
Would the additional information about a company’s $300,000 lease liability (“loan”) affect your decision to invest or loan them money?
For many of us, the answer is yes. At the very least, we would want to know the nature of the commitment (length, payment terms, renewal period, and lease break options). Creditors want to know the company has the financial strength to repay their commitments and investors want to know the company is able to remain solvent and provide a return (dividend).
While some of this information about the lease was presented in the notes section, mentioning the actual cost on their financial statements, it was not presented on the face of the statement and not included in related metrics or key performance indicators (KPIs) such as:
1. Current Ratio – reflects an organization’s ability to pay all financial obligations in one year.
2. Quick Ratio (Acid Test) – indicates whether a business has sufficient short-term assets to cover its near-future liabilities.
3. Debt-to-Equity Ratio – shows how effectively a business is using their shareholder investments. A key ratio evaluated by lenders to determine the amount a company is leveraged.
Why Accounting for Leases has Been a Problem
Generally Accepted Accounting Principles (GAAP) requires companies to report loans and other debt on their financial statements but, until recently, did not address many leases. This information helps investors and creditors understand the full financial picture of an organization. Failure to present all liabilities (debts) on the financial statements misleads investors and creditors to make decisions they may not otherwise make.
The FASB has worked with the International Accounting Standards Board (IASB) since 2013 to align the method of accounting for leases. Both organizations believed the balance sheet should reflect the lease obligation instead of simply disclosing it in a note. The FASB released Accounting Standards Codification (ASC) 842 on February 25, 2016 and the IASB released IFRS 16 on January 13, 2016. We’re going to focus on ASC 842 since most U.S. government contractors follow U.S. GAAP.
All leases over 12 months, whether previously considered financing (capital) leases or operating leases. These include formal and informal lease agreements and month-to-month agreements where utilization beyond 12 months is likely or expected.
Common examples of different types of leases a government contractor may have:
- Buildings (offices, warehouses)
- Cars, trucks, and heavy equipment (tractors, dozers, forklifts)
- Manufacturing equipment (stamps, presses, lathes, ovens)
- Office equipment (computers, servers, copiers, printers)
- Furniture (desks, chairs, cubicles, workstations)
Concern for Government Contractors
What This Means For Future Business
The new standard will increase most companies’ debt-to-equity ratios since they will now have to report the liability associated with their leases. The change, in this common key performance indicator (KPI), will cause lenders to reconsider future agreements and may affect existing debt covenants. Here are a few actionable measures you can take to look out for your future business when it comes to the new rules:
- Add a clause to existing debt agreements for the debt-to-equity ratio calculation to be based upon rules in force at the time of the original agreement instead of the new rules.
- Revisit the lease vs purchase decision for future acquisitions.
- Include a facilities cost of capital (cost of money) calculation in all future cost proposals.
- Work with a CPA to provide clarity, guidance or classification relevant to your specific circumstances.[iii]