On February 25, the Financial Accounting Standards Board adopted ASU No. 2016-02, Leases (Topic 842), which establishes new principles governing financial reporting about the assets and liabilities that arise from leases. The standard, which has been under consideration since 2006, is summarized in the December 2015 Update. It will require lessees to recognize assets and liabilities for leases with terms of more than 12 months and will affect the financial statements of virtually all companies that lease assets. For public companies, the ASU will take effect for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. For all other organizations, it is effective for fiscal years beginning after December 15, 2019, and for interim periods within fiscal years beginning after December 15, 2020.
In the press release announcing adoption of the new guidance, FASB Chair Russell G. Golden stated that the leasing ASU “responds to requests from investors and other financial statement users for a more faithful representation of an organization’s leasing activities.” Further, it “ends what the U.S. Securities and Exchange Commission and other stakeholders have identified as one of the largest forms of off-balance sheet accounting, while requiring more disclosures related to leasing transactions.” In a paper entitled Understanding Costs and Benefits, the Board states that the new guidance will result in “fewer opportunities for organizations to structure leasing transactions to achieve a particular accounting outcome on the statement of financial position” and will improve “understanding and comparability of lessees’ financial commitments regardless of how the lessee finances the assets used in its businesses.”
However, as the Costs and Benefits paper acknowledges, some companies may face significant implementation costs and challenges. “For example, organizations will, in general, incur initial costs to educate employees about how to apply the new requirements, and to explain to users the effects of the changes in accounting for leases on the organization’s financial statements. In addition, many organizations may need to consider supplemental processes and controls to ensure that they capture leasing activity on the balance sheet.”
Comment: Companies that engage in any significant amount of leasing should analyze the challenges that the new standard will pose and formulate an implementation plan as soon as possible. Some of the issues that the audit committee may want to raise with management include –
- The need for new data collection, storage, and maintenance processes. Companies will need to create a data base of their existing leases – something that they may not have found necessary under the current accounting regime – and determine the assets and liabilities arising from those leases after the ASU becomes effective. Procedures will also have to be put in place to capture this information for future leases.
- The need for IT upgrades. The new data collection, retention, and processing needs may require changes in the information technology that supports leasing activity.
- Changes in internal controls. In light of the Securities Exchange Act internal control requirement and Sarbanes-Oxley Act assessment and auditing requirements for internal control over financial reporting, as new processes are created to comply with the leasing standard, it will be necessary to make sure that those processes are consistent with the company’s control framework and are operating effectively.
- The impact on debt covenants and financial ratios. The inclusion of lease assets and liabilities on the financial statements will affect traditional financial measures, such as the debt-to-equity ratio and return on total assets. It may be necessary to renegotiate loan covenants with existing lenders to avoid breaches resulting from these changes. The impact of the new standard will also need to be taken into account in future loan negotiations.