Beginning next year, all private companies will have to include each of their leases – from company cars to office space to equipment – on their balance sheets.
The new accounting standard is a big shift – Moody’s Investors Service last month described it as “one of the most transformative accounting changes in recent history” – and experts say companies should start preparing for it now.
“The big thing that people need to do is really, you need to have some kind of strategy to develop and collect all of the data and information that you need,” said Mike Kuhn, shareholder at Vrakas CPAs + Advisors in Brookfield. “It’s pretty simple if you’re a company with just one lease for a facility, but if you’re a company with multiple locations, those leases a lot of times aren’t tracked real well.”[caption id="attachment_375637" align="alignleft" width="150"] Kuhn[/caption]
According to the Financial Accounting Standards Board, which issued the Accounting Standards Update on leases in 2016, this change affects all companies and other organizations that lease assets. Any lease with a term 12 months or longer is included. The standard went into effect for public companies this year, and will go into effect for most private companies beginning in 2020.
The FASB made the change, it said, because while capital leases are already included, operating leases are not recognized on balance sheets. It argues including all leases will increase transparency in financial reporting.
The first step a business should take, Kuhn said, is to identify all its leases and review the terms of them.
“Really just to see if there is any variable payment components, if there’s any options for how long the lease would be, the amounts and any increase in the cost,” he said. “Really what you’re doing is you’re identifying what the lease payments are going to be that you expect to make and then you’re valuing them using a net present value.”
Balance sheets will look much different, mainly because they will contain higher numbers with the inclusion of liabilities for future lease payments, Kuhn said.
“It certainly could affect some bank covenants for some companies” if they use debt-to-equity ratios, he said. “I think they’ll be able to maintain them, it’s just making sure the covenants are not something that you’re going to fail just because of this change in accounting. And I anticipate the bankers are smart enough to figure out how to do that.”
The standard change could also impact companies’ budgeting and planning to some degree.
“I think companies will start having some better internal controls over leases,” Kuhn said. “If they’re sensitive to what the financial statements look like, lease versus buy financial decisions could have some changes. Really the underlying what’s happening isn’t changing, it’s just what’s being reported is changing.”
Hartford-based startup LeaseCrunch LLC has developed accounting software specifically tailored to the impending lease accounting change. Co-founder Ane Ohm is marketing it to CPA firms preparing to implement the standard for their clients with multiple leases.[caption id="attachment_375635" align="alignleft" width="150"] Ohm[/caption]
The LeaseCrunch platform has a wizard that guides the accountant through properly categorizing each lease, evaluating the terms of each lease, and providing the correct footnote disclosures.
As a former auditor, Ohm said she knows what auditors need to see on a company’s balance sheet. She’s been asking CPA firms she works with to talk to their clients about the new standard during their busy season.
Ohm recommended business owners start a conversation with their bankers early regarding potential impacts on debt covenants as a result of the added liabilities on their balance sheets come 2020. Banks can only show so much liability to regulators, so there is a potential impact for their clients who are on the edge.
It’s also important to make new policy elections related to leases across the company, because the new standard requires those decisions to be documented, Ohm said.
Among the potential leases a company holds are office space, company cars or trucks, photocopiers or equipment. If a company is in the process of constructing a building and physical assets are leased through that contract, such as a crane, even those embedded leases are part of the equation.
“One of the things you need to do is go through your expenses…and look for things that could be considered assets,” Ohm said. “As long as it’s a physical asset.”
It will be important to gather key dates, terms and details of those leases for inclusion in the financial disclosures, she said. Often, leases are locally managed at a particular branch and haven’t been treated as an expense, and now businesses must do consolidated reporting on them.“There’s no standard with leases,” Ohm said. “I could rent anything from you, you could write it up and those are our lease terms.”