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!