The Financial Accounting Standards Board (FASB) is gearing up to align U.S. standards with global accounting standards, increasing transparency in financial reporting and altering the way companies account for their leases.
The mandate will become effective for most businesses in January 2019 — a date that might seem far into the future, but preparing to comply might take more time and resources than you think. In fact, 31% of executives feel their organizations are unprepared, according to a recent Journal of Accountancy article.
What’s so complicated about new lease accounting standards?
Under the new rules, you’ll be required to report your leases as both assets and liabilities on your balance sheet. This applies to real estate, vehicles and equipment. What’s more, the rent obligations that your leases reflect are essentially recognized as debt — which could pose a danger to your credit and bottom line.
Current lease accounting treats leases as either capital or operating leases, and there are specific rules as to their classification. But under the new law, the FASB has mandated all leases whether Type A (financing or capital) or Type B (operating) be capitalized on the balance sheet, including the related lease liability.
For example, consider your debt covenants with banks. Many loan documents include various debt covenants, such as debt to equity ratio or debt service coverage ratio as well as prohibitions against incurring new debt. But operating leases, which are currently included only in footnote disclosure, are nowhere to be found on the typical balance sheet.
FASB standards will also require Type B leases to be recorded as an available-for-use asset with a corresponding lease payable. What does that do to your bank covenants, or better yet, for nonprofit organizations? How do you explain the rent in your current grants being reflected as interest?
There’s no better time than the present
Companies will have to take a closer look at what they classify — or fail to classify — as lease agreements. Keep in mind, this includes options to lease for future expansion, which you’ll be required to treat as if they’re reflected on the books right away. It may even motivate tenants to purchase their buildings outright since they’ll be handled the same way as renting — another obligation on the balance sheet.
By preparing now, you’ll gain a clearer idea of what to expect in the coming months, and ultimately, save money and gain peace of mind without the last-minute scramble as the deadline nears. If you haven’t already, set up a meeting with bankers and funding sources and begin a dialogue regarding the possible effects of the new accounting standard on your grant funding and loan covenants. Act now and avoid any surprises from your accountant or auditor in 2020.