In a previous post, we outlined the top five biggest changes companies face in implementing the new lease accounting standard. Why are we even talking about ASC 842? Because it’s going to be HUGE! And that’s the subject of this week’s post as we discuss the impact the new lease accounting standard (ASC 842) will have on companies’ balance sheets.
According to the IASB’s press release announcing the publication of IFRS 16 Leases, “listed companies using IFRS Standards or U.S. GAAP are estimated to have around US$3.3 trillion of lease commitments; over 85 percent of which do not appear on their balance sheets.” Why? Because to date leases were either categorized as either ‘finance leases’ (which appeared on the balance sheet) or ‘operating leases’ (which were only disclosed in the notes to the financial statements).
Well no more! With the adoption of the new lease accounting standard, not only will companies be required to bring lease commitments onto their balance sheets, but the overall accounting for leases is changing!
As discussed above, ASC 842 requires all leases, including operating leases, be recorded on the balance sheet. This new requirement affects both assets and liabilities and will absolutely “blow up” the balance sheet!
The accounting for finance leases is similar to the accounting for capital leases under current U.S. GAAP where the lease is required to be recognized on the balance sheet. However, the accounting for operating leases is changing substantially.
So, how do operating leases get recorded on the balance? ASC 842 requires a lessee to recognize a right-of-use (ROU) asset and a lease liability. The lease liability is calculated based on the present value of lease payments to be made over the lease term discounted at the rate implicit in the lease, if known, or the lessee’s incremental borrowing rate, which is more likely. The ROU asset is the same amount as calculated for the lease liability, adjusted for any initial direct costs, prepaid lease payments or lease incentives received.
In subsequent reporting periods, lessees would recognize periodic lease expense, amortize the ROU asset, and accrete the lease liability using the effective interest method as follows:
As you can see, the new accounting for operating leases under ASC 842 will substantially impact the balance sheet. This is especially true for companies with numerous operating leases such as airlines, retailers, grocery stores, and drugstores. Take for example, Walgreens, who, according to a report by LeaseAccelerator, has approximately US$34 billion worth of operating leases they will have to bring onto their balance sheet!
Now that we know how operating leases are going to be recorded in the financial statements, let’s discuss why the guidance changing using an example.
Imagine you are an investor and are considering investing in a company. You decide to analyze the balance sheet of the company (see below) because it reflects what the company owns and owes, and is a good indicator of the financial strength of the company.
Based on your review of the balance sheet, the company has cash-on-hand, a pool of investments, and no short- or long-term debt. In fact, their debt-to-equity ratio is only 1.2, which indicates that they use minimal debt to run their business. This company seems to be the ideal company to invest in, right?
Now, let’s take a look at the same example balance sheet, but after the company has adopted ASC 842.
What are your thoughts about this company now? They still have cash-on-hand and a pool of investments, but, because of the adoption of ASC 842, both their assets and liabilities increased. Now their debt to equity ratio is 2.8, a 133% increase, and indicates the company relies on substantial debt to run their business. Would you invest in this company now?
This example helps to paint the picture of why the lease accounting guidance is changing. The balance sheet is a “selfie” in time – it shows what a company owns and owes. But under the current guidance operating leases are considered “off-balance sheet” and, therefore, the balance sheet isn’t accurately depicting what companies owe. For this reason and others, current U.S. GAAP has been criticized for not providing users of the financial statements with the information necessary to understand a company’s leasing activities, hence the reason for the new standard.
Although “blowing up” the balance sheet is getting the most attention with respect to the new lease accounting standard, there are other changes too. Also, even though ASC 842 isn’t effect for public business entities until 2019, companies will need to make changes to their systems, process, and internal controls when implementing the new standard. Need help implementing the new standard? Check out this list of “go-to” resources or give us a call!
Disclaimer
This post is published to spread the love of GAAP and provided for informational purposes only. Although we are CPAs and have made every effort to ensure the factual accuracy of the post as of the date it was published, we are not responsible for your ultimate compliance with accounting or auditing standards and you agree not to hold us responsible for such. In addition, we take no responsibility for updating old posts, but may do so from time to time.
Comments (9)
Rick Kazmier:
Apr 20, 2018 at 10:13 AM
I have read many articles on this subject and many articles classify the debt from operating leases as a "Non-Debt Liability." This non-debt liability is said to be excluded from covenant calculations.
1) Is the classification as a "Non-Debt Liability" defined in the ASU or anywhere in GAAP
2) Is exclusion of "Non-Debt Liability" discussed in the ASU or anywhere else in GAAP
All loan documents require GAAP accounting. This change can dramatically impact covenant calculations, as you point out in the example. My question stems from understanding the legal basis banks, their customers and regulators will have regarding these changes.
Thank you
Rick Kazmier:
Apr 20, 2018 at 10:13 AM
I have read many articles on this subject and many articles classify the debt from operating leases as a "Non-Debt Liability." This non-debt liability is said to be excluded from covenant calculations.
1) Is the classification as a "Non-Debt Liability" defined in the ASU or anywhere in GAAP
2) Is exclusion of "Non-Debt Liability" discussed in the ASU or anywhere else in GAAP
All loan documents require GAAP accounting. This change can dramatically impact covenant calculations, as you point out in the example. My question stems from understanding the legal basis banks, their customers and regulators will have regarding these changes.
Thank you
Mike Walworth, CPA:
Apr 20, 2018 at 11:23 AM
Thanks for your question, Rick. I believe the classification is addressed within the Basic of Conclusions, stating that the lease liability is an operating liability rather than debt. Check out this paragraph in ASU 2016-02 (BC 14) which states:
The Board further considered the concern that the additional lease liabilities recognized as a result of adopting Topic 842 will cause some entities to violate debt covenants or may affect some entities’ access to credit because of the potential effect on the entity’s GAAP-reported assets and liabilities. Regarding access to credit, outreach has demonstrated that the vast majority of users, including private company users, presently adjust an entity’s financial statements for operating lease obligations that are not recognized in the statement of financial position under previous GAAP and, in doing so, often estimate amounts significantly in excess of what will be recognized under Topic 842. The Board also considered potential issues related to debt covenants and noted that the following factors significantly mitigate those potential issues:
a. A significant portion of loan agreements contain “frozen GAAP” or “semifrozen GAAP” clauses such that a change in a lessee’s financial ratios resulting solely from a GAAP accounting change either:
1. Will not constitute a default
2. Will require both parties to negotiate in good faith when a technical default (breach of loan covenant) occurs as a result of new GAAP.
b. Banks with whom outreach has been conducted state that they are unlikely to dissolve a good customer relationship by “calling a loan” because of a technical default arising solely from a GAAP accounting change, even if the loan agreement did not have a frozen or semifrozen GAAP provision.
c. Topic 842 characterizes operating lease liabilities as operating liabilities, rather than debt. Consequently, those amounts may not affect certain financial ratios that often are used in debt covenants.
d. Topic 842 provides for an extended effective date that should permit many entities’ existing loan agreements to expire before reporting under Topic 842. For those loan agreements that will not expire, do not have frozen or semifrozen GAAP provisions, and have covenants that are affected by additional operating liabilities, the extended effective date provides significant time for entities to modify those agreements.
Also, check out Question 6.1.10 within KPMG's Lease Handbook available for download at this link:
https://frv.kpmg.us/reference-library/2017/06/handbook-leases.html
LKS:
Jul 16, 2018 at 02:41 PM
Can you confirm that the total lease liability is classified on the balance sheet long-term as opposed to presenting short and long-term pieces?
Mike Walworth, CPA:
Jul 18, 2018 at 01:18 AM
Thanks for your question LKS. Here's what ASC 842 says about presentation:
842-20-45-1 states a lessee shall present in the statement of financial position or disclose in the notes all of the following:
a) Finance lease ROU assets and operating lease ROU assets separately from each other and other assets
b) Finance lease liabilities and operating lease liabilities separately from each other and from other liabilities.
ROU assets and leases liabilities shall be subject to the same considerations as other nonfinancial assets and financial liabilities in classifying them as current and noncurrent in classified statements of financial position.
ASC 842-20-45-2 through 45-3 talk about further presentation issues.
Hope it helps!
michael duffy:
Jan 28, 2019 at 04:49 PM
does this standard apply to a small division that rolls its financial statements up to a larger parent division that public reports numbers?
Mike Walworth, CPA:
Jan 30, 2019 at 12:20 PM
Thanks for your question, Michael. The answer is "Yes", although I'd check with the parent to make sure it hasn't already been done on a top-side basis (otherwise they leases would be double-counted). I'd also check on their materiality threshold.
Marie Constant:
Feb 10, 2019 at 12:26 PM
The FASB recently issued ASC 842 on lease accounting. ASC stands for Accounting Standards Codification. Try to research how this new pronouncement on leases reduced the problem of "off balance sheet financing." Many lessees were able to keep a liability for the lease obligation off of their balance sheets under the old rules. How did the new rules under ASC 842 make it more difficult for lessees to keep this liability off of their balance sheets?
Mike Walworth, CPA:
Feb 11, 2019 at 10:07 AM
Thanks for reading, Marie. Yes, the new rules under both U.S. GAAP (ASC 842) and IFRS (IFRS 15) make it more difficult for leases to keep lease liabilities off their balance sheets because the new standards REQUIRE all leases to be recorded on the balance sheet. There are some exceptions such as "low value" assets (IFRS only) and short-term leases (both IFRS and US GAAP), but, for the most part, all LEASES will be reported. I capitalize "LEASES" because that becomes the de facto off-balance sheet test. In other words, the way to get out of recording a lease on the balance sheet is to ensure that the contract does not meet the definition of a lease. See this post for further discussion:
https://www.gaapdynamics.com/insights/blog/2019/01/29/why-is-everybody-freaking-out-about-embedded-leases-asc-842/
Hope it helps!
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