It is not too early to start implementing FASB ASC-842 and plan ahead.
If you’re with a US publicly held company, you are certainly already involved in implementing FASB ASC-842 (Accounting Standards Codification – Topic 842 – Lease Accounting). Privately held companies have an extra year (unless they choose to adopt early) but must be in compliance for all calendar or fiscal years starting after December 15, 2019. Since it is already the beginning of 2019, there is not much time left to prepare for the required changes.
The main change in the way companies account for leases is the inevitable inclusion of operating leases’ liabilities and assets on lessee companies’ balance sheets in addition to Finance Leases (formerly known as Capital Leases). Lessor companies also have certain changes to comply with but in this post, I am going to focus only on lessees, as they represent the majority of companies that lease equipment, land, production facilities and office space.
Why is this change so significant?
As with any ASU (Accounting Standards Update), companies must review and revise one or more of their accounting and/or reporting processes. There is training to be done, re-writing guidelines and desktop procedures, adding or revising use of certain GL accounts and possibly a modified integration of some transactions to the GL and in some companies revising internal audit processes and procedures.
The modified processes have to be tested prior to going live and must be functional and operating correctly when the new standards go into effect, so getting started early has obvious benefits.
However, with this ASU there is one very important factor to consider and that is the changes to the balance sheet which may be quite radical for certain companies. Since operating leases have been off the balance sheet for as long as I remember (hence the term off-balance sheet financing), putting them back on the balance sheet may come as a shocking surprise to some people, as this change can considerably increase liabilities and assets, depending on the nature of the leases.
Currently, many companies have a high number of operating leases since in the past they were able to finance the acquisition of production equipment, machinery and facilities though entering these lease agreements without substantially affecting their ability to borrow money for other purposes.
So why do companies need to pay close attention to these changes in their balance sheets?
At first, it may seem that adding an equal amount to assets and liabilities should not make much difference on the financial condition of the company but consider this:
The lease liability (and equally valued right-of-use asset) added must represent a present value of all future lease payments (on all existing and new operating leases). This value can be substantial, especially with multiple operating leases. Real estate leases can represent an enormous amount that must be included on the balance sheet as these are usually long-term leases with very high future payments when added together.
Certain financial ratios, especially those used by lenders to qualify customers for new loans and to monitor existing customers’ financial loan covenants are certainly going to be adversely affected, to a point that some companies may find themselves in a technical default of their business loan agreements. One example might be the total liabilities to tangible assets ratio, always present in asset-based lending loan agreements. That ratio may quickly rise and exceed the permitted value under the agreement.
For this reason alone, I urge all our client companies to plan for this accounting change ahead of time which is true for all companies with current operating leases affected by this ASU. Furthermore, this should be part of the planning process followed by the budget process and must include forecasted changes to operating leases.
This implies that companies must be able and willing to forecast their balance sheets and that the forecasted balance sheet must be perfectly synchronized to the income statement which is driven by the underlying budget.
This is a good time to consider implementing a planning, budgeting and analysis software solution where a complete and accurate (as accurate as the budget itself) forecasted balance sheet is part of the solution.
Now is the time to plan for these changes to lease accounting and update your financial systems and the software driving them. Don’t wait until next year or when your next annual budget cycle begins.