Lease accounting overhaul: Are you ready?

FASB's new lease accounting rule requires all leases be accounted for as capital leases, other than those with a maximum possible term of 12 months or less. Leases will be capitalized at the present value of the lease payments, resulting in recognition of a lease asset and liability.

How will this affect your organization?

• It will be critical to consider the effect of the new rules on your organization’s debt covenants. All things being equal, debt to equity ratios will increase as a result of adding lease liabilities to the balance sheet. Lenders and borrowers may need to consider whether to change required debt to equity ratios as they negotiate the terms of loan agreements.
• When calculating the amount to capitalize (i.e., the present value of lease payments), you are required to include renewal options if there is a significant incentive to renew (e.g., a major investment in leasehold improvements that you wouldn’t want to walk away from, or a substantial penalty for nonrenewal).
• In most cases, the present value of lease payments would be measured using a discount rate that equals the lessee’s current borrowing rate (i.e., what it could borrow a comparable amount for, at a comparable term).
• Handling amortization of the lease asset and liability will change as well:
  
  For finance leases, follow the current methodology for capital leases, i.e., use the effective interest method to amortize the liability, and your regular depreciation method (typically straight-line) for the asset. Note that this has the effect of “front-loading” the expense into the early years of the lease.
  
  For operating leases (e.g., equipment and some property), the lease asset and liability would be amortized to achieve a straight-line expense impact for each year of the lease term. (Leases that cover the major part of the useful life of equipment would be amortized in the same manner as finance leases.)

The effective dates for the new provisions

• Public business entities: Fiscal years beginning after December 15, 2018, including interim periods within those fiscal years.
• All other entities: Fiscal years beginning after December 15, 2021, and interim periods within fiscal years beginning after December 15, 2022.

Our accounting and auditing experts can answer questions about your particular circumstances and issues.