Impacts how businesses account for leased property, which could have a significant impact on a business’s ability to meet existing debt covenants or possibly even their ability to secure new financing.
A new Generally Accepted Accounting Principles (GAAP) lease standard, FASB ASC 842, became effective for fiscal years beginning after December 15, 2021, for non-public companies. There are two types of leases under the new lease standard: an operating lease and a finance lease. This article focuses on operating leases.
Prior to implementation of the new lease standard, accounting for operating leases under GAAP was relatively simple. Generally, a business would expense their operating lease payments every month and there was no asset or liability recorded on the balance sheet (unless the lease had escalating lease payments or certain other features). However, a business was required to disclose any future minimum lease payments in the notes to their financial statements. Essentially, disclosing their liability for future lease payments under the lease contract.
Under FASB ASC 842, the new lease standard that recently went into effect for non-public entities, companies are now required to record a liability for the present value of the future lease payments, with a corresponding "right-of-use" (ROU) asset. The entity will then expense the lease payments on a straight-line basis, similar to the prior lease standard. The reason? It will more accurately reflect a business’s current financial situation.
What qualifies as an operating lease under the new lease standard? The standard defines leases as contracts or portions of contracts that give control over a physical asset for a specific period of time in exchange for consideration (typically cash payments). Examples include office space, buildings, computers, vehicles and equipment. Instances of leases not covered by the new lease standard includes software subscriptions and leases for intangible assets.
The impact of this change can be significant for small to mid-size business owners, many of whom may not be prepared to meet the new requirements. Here’s what you need to know to bridge the "GAAP" (pun intended) in your accounting records moving forward.
Assess your liabilities
If your organization’s financial statements are prepared on the GAAP basis, there could be a few obstacles on the road to implementing the new leasing standard requirements: (1) Identifying all the companies’ leases that are subject to the new standard; (2) Identifying provisions in each lease that affects the calculation of the ROU asset and/or lease liability; (3) Calculating the ROU Asset and/or lease liability (4) Effects of implementing the new standard on debt covenants.
In the past, your company would not have included the ROU assets and corresponding lease liabilities on your balance sheet, but now they will be included under the new standard, which could have a significant impact on your business’s debt covenants. For example, if your business leases an office building for $6,500 per month for 10 years, a lease liability of about $644,000 would have to be included on your balance sheet (assuming a 4% discount rate). That’s a fairly large increase in liabilities, which could in turn throw off some of your company’s debt covenant ratios and could result in a bank not renewing or calling a loan.
Potential solutions
To help prepare for and offset likely obstacles, business owners should take a couple steps. First, talk to whoever is requiring your business to prepare your financial statements on GAAP basis to see if they are willing to accept financial statements that are prepared on a different basis of accounting. If they cannot accept financial statements prepared on different accounting basis, discuss the effects of the new lease standard on your financial statements and how implementing the new lease standard could impact pertinent ratios and come up with a game plan to address these changes (i.e. how to address failed debt covenants as a result of implementing the standard).
Second, if your business’s financial statements are currently on GAAP basis and you can move away from GAAP to another basis of accounting, you may want to consider doing so. GAAP basis does not differentiate between small and mid-sized businesses versus major corporations that have a dedicated accounting department that can implement the new standard. Leases for smaller items, like copiers or postage machines, may not seem like large expenses in the grand scheme of things but could be subject to the new standard. This could make your company’s accounting more complex, increasing the time it takes to prepare your monthly financial statements.
Time to call a professional
The new lease standard can be an overwhelming undertaking for many small business owners, both in terms of time needed and the complexity involved. Speaking with a professional that has the expertise and resources to properly handle your reporting requirement can save you unnecessary trouble – and dollars – in the long term. New standards brings new complications. Having a professional available to advise you of the best solution for your company can go a long way.
RUDLER, PSC CPAs and Business Advisors
This e-Tip is presented by Chris Guidugli, CPA.
If you would like to discuss your particular situation, contact Chris at 859-331-1717.
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