New lease standards originally issued back in February 2016 went through a series of extensions due to the pandemic and contention. The new lease standards are finally effective for non-public entities for annual periods beginning after December 15, 2021. The new lease standard overrides all previous lease standards and significantly changes how all leases will be presented and shown within your financial statements.
As part of the new standard, the term “capital lease” has now been replaced with “finance lease,” and even further, the definitions of what creates a finance lease have been reworked and have created more of a gray area. The presentation of finance leases has also been slightly adjusted.
If the lease is not considered a finance lease, it is considered an “operating lease,” just like it has been called. However, the most significant impact of the new lease standard is that operating leases are now presented on the balance sheet, similar to finance leases.
Balance Sheet Presentation
A Lease Liability and a Right of Use asset (ROU) will now be established on the balance sheet for both finance and operating leases. The lease liability amount is calculated as the present value of the future lease payments. The ROU asset is calculated as the lease liability amount plus any initial direct costs of obtaining the lease, any payments made to the lessor before the commencement, and less any lease incentives received within the lease agreement. The ROU asset is now considered an intangible asset and is no longer considered part of property, plant, and equipment.
Income Statement Presentation
Finance leases are expensed through two expenses accounts, interest expense based on the amortization schedule of the lease liability and straight-line amortization expense of the ROU asset. Operating leases are expensed through one lease expense account determined through amortization schedule entries of the lease liability and adjustments to the ROU asset that result in a straight-line expense of the lease through its determined lease term.
As noted above, the biggest change within the new lease standard is on operating leases. If a company has a substantial amount of, or complicated operating leases on the books, it will require a significant amount of time and skill for their accounting personnel to calculate the present value of the future lease payments, prepare and maintain each separate amortization schedule, as well as perform the required entries monthly. Companies may request assistance from their CPAs which than would further impact them in added costs.
This new lease standard significantly grosses up the balance sheet which will have an impact on existing debt covenants like debt service coverage ratios and current ratios. The Company will also appear more leveraged, and since the ROU is now considered an intangible asset, it will also impact any tangible net worth calculations negatively.
What Should You Do Now
The new lease standard is no longer getting extended and will be in effect for your 2022 operating year. The first steps will be to determine if your personnel can handle these changes internally or if you will need to outsource the work to someone else, whether on an initial, annual, or monthly basis. Once you have analyzed, calculated, and adjusted for all of your lease agreements. You can determine the overall impact and if conversations need to be started with your banks and lenders on potential or unforeseen covenant or ratio issues related to this new lease standard. Determining the impact and having these conversations early may significantly reduce complications when entering into new debt agreements or extending current ones.
DHJJ Can Help
DHJJ helps clients navigate this complex and challenging change in lease accounting standards with our Accounting and Assurance team.
Financial Accounting Standards Board – ASU 2016-02 – Topic 842