written by Josh Beaird
In less than one year, a significant change to generally accepted accounting principles (GAAP) will become effective.
Public business entities must begin adopting the new lease accounting standard — ASU No. 2016-02, Leases (Topic 842)— for interim and annual periods beginning after Dec. 15, 2018. For nonpublic business entities, the deadline is Dec. 15, 2019.
Current rules allow leases classified as operating leases to be off-balance-sheet and expensed as amounts due are incurred. Therefore, many leases that your customers currently have may not show up on the balance sheet.
Businesses that prepare GAAP compliant financial statements will have to start recognizing assets and liabilities on the balance sheet for all leases longer than one year in duration. This means they will have to report a right-of-use asset and corresponding liability for the operating lease payment obligation discounted to present value.
The new method could have a negative impact on leverage, debt service coverage and liquidity ratios, which may decrease a business’s chances of obtaining a loan or cause a violation of debt covenants. Retail businesses and professional service providers, such as medical practices, that lease their facilities could be impacted the most, as many real estate leases are currently classified as operating.
The Financial Accounting Standards Board (FASB) has drawn a distinction in classification between operating lease liabilities and debt. FASB noted that the effect of Topic 842 on entities’ covenants in existing debt or loan agreements can be alleviated by the following:
- A significant portion of lease agreements contain “frozen GAAP” or “semi-frozen GAAP” clauses. Accordingly, a change in a lessee’s financial ratios that results solely from a GAAP accounting change either doesn’t result in a debt covenant default or simply requires both parties to renegotiate in good faith.
- Operating lease liabilities are operating obligations rather than debt. Based on outreach, this decision by the FASB on disclosure as operating liabilities may substantially alleviate issues for some smaller entities with certain debt covenants.
- There’s still time before the guidelines must be adopted. The average life of most commercial and industrial loans—based on data obtained by FASB staff—means that many loans will be renegotiated before the effective date for ASC Topic 842 (especially private companies).
Therefore, now is the time to make sure your loan agreements are properly structured to accommodate the new standard. Please contact us if you have more questions about the new lease accounting standard 417-881-0145.