The Financial Accounting Standards Board (FASB) is expected to finalize new lease accounting standards (“Standards”) within the coming months which will have very real consequences for owners and lessees alike. Under current accounting standards, a lease is classified as a “Capital Lease” or an “Operating Lease.” A capital lease is treated similarly to a loan; the asset is treated as being owned by the lessee and must be recorded as an asset on the lessee’s balance sheet. By contrast, an operating lease gives the lessee a right to use the owner’s asset without the requirement of including the lease on its balance sheet. The lessee never owns the asset and must return it to the owner after the lease ends. Most office building, retail, or other standard commercial leases are operating leases under the current standards.
The new Standards will, among other things, eliminate the above classification and instead classify most capital leases –including existing capital leases –as a “Type A Lease”, which will be accounted for in substantially the same manner as capital leases are accounted for under existing generally accepted accounting principals (GAAP), and most operating leases – including existing operating leases –as a “Type B Lease”, which will be accounted for in a manner similar to operating leases under existing GAAP, except that lessees will now be required to include lease obligations on their balance sheets increasing assets and liabilities. Shorter term leases, leases of 12 months or less, must also be included on balance sheet if, considering all relevant economic factors, the lessee is “reasonably certain” to exercise an option to extend the lease beyond 12 months.
The above changes, among others, are intended to increase transparency and comparability among organizations that lease assets, by recognizing the assets and liabilities that arise from lease transactions. This transparency is intended to provide a clearer picture of company economics to investors, lenders, the Securities and Exchange Commission, and the international business community.
The new Standards will affect owners, lessees and other professionals across the spectrum in many ways including:
- Lessee’s reevaluating whether to lease or buy assets;
- Lessee’s updating their lease systems, processes and related internal controls;
- Increasing costs in administrative and accounting responsibilities, including data collection and reporting; and
- Owners and lessees renegotiating and restructuring current leases.
The FASB Standards will take effect for public companies in fiscal years beginning after December 15th, 2018, including interim periods within those fiscal years. For private companies, the Standards will be effective for annual periods beginning after December 15th, 2019.
By anticipating and understanding how new and existing leases will be classified and accounted for, owners and lessees will be in a better position to develop strategies that minimize possible negative impacts the Standards bring. This will require owners to work hand-in-hand with their accountants and legal counsel to craft leases that satisfy concerns raised by lessees due to the potential impacts of the Standards on their financial statements, while protecting owners’ interests.
To view FASB’s Accounting Standards Update relating to Leases issued on February 25, 2016, click here.