Numerous changes occur in the U.S. financial accounting and reporting standards each year, but only a handful affect every company—large or small, technology-based or traditional service providers—and one of those takes effect soon.
Companies starting in the next couple of years must list all of their leases on annual accounting reports, a change that could affect their ability to secure lines of credit, among other financial ramifications.
Navigating the change and others on that scale requires professional service providers, such as accountants, to help companies carry out sound due-diligence procedures.
The Business Journal’s Michael de los Reyes asked local accounting firm executives to share their thoughts on the new lease accounting requirements enacted by the Financial Accounting Standards Board.
Here are edited excerpts of their responses:
Deana Bowden
Audit and Assurance Partner
White Nelson Diehl Evans LLP
Irvine
In 2016, the Financial Accounting Standards Board issued a new leasing standard, ASU 2016-02. Starting in 2019 for public companies and 2020 for privately held companies, a capital lease will be referred to as a finance lease, and an operating lease will be referred to as a use lease (a right to use). A finance lease will essentially be accounted for in the same way as a capital lease is now.
A use lease is a bit more confusing. It will now record a right of use (ROU) asset and a liability. These leases will be recorded at the present value of the payments discounted at the rate implicit in the lease, if known, or the lessee’s incremental borrowing rate.
Here at White Nelson Diehl Evans LLP, we are making our clients aware of the upcoming changes, and we are developing templates for our clients to better serve them when the time comes for implementation. There needs to be early review and planning to ensure completeness, accuracy and adherence to the new standard. The impact to the financial statements could be significant, as there will now be new separately stated long-term assets and current portion and long-term liabilities. Additionally, various ratios could be affected, such as working capital, debt to equity, and asset turnover.
Implementation of the new standard will not only affect how leases are accounted for, but also likely lease-versus-buy decisions, negotiations of lease terms, banking covenants, related party transactions, and evaluation of tax reporting consequences, as new book-to-tax differences will be created.
Our advice is don’t wait to do the analysis, as it will only make implementation harder. Plan ahead and arrange for resources.
Deborah Dickson
President
Smith Dickson
Irvine
Among our clients’ greatest concerns is bank financing and covenant compliance. The new Financial Accounting Standards Board lease accounting standard will cause them to ask, “Will my line of credit be renewed? What amount? If not, how can I find another bank that will help?” We are explaining to clients that by following the new standards, they may not have to worry about negotiations with their bankers. Banks have always been aware of operating lease obligations (which are impacted more than capital leases by the new standard) because they have been disclosed in footnotes. It is possible that banks may choose to exclude operating leases from debt ratio compliance, in which case the impact of the new FASB standards may be negligible to many companies.
As for clients’ internal accounting, we advise our clients that they should anticipate a few necessary adaptations. Lessees will be required to provide additional disclosures to help users of financial statements better understand the amount, timing and uncertainty of cash flows related to leases. They will need to develop processes and controls to collect the necessary information. Lessors will likely see minimal change to their accounting. They may find that lease negotiations with lessees change, as lessees may seek to modify lease terms to help with their financial statement issues.
Mark Hughes
Southern California Audit Practice Leader
Grant Thornton LLP
Irvine
From a lessee’s perspective, the most significant change for clients in this space is that lessees are required to recognize the rights and obligations resulting from most operating leases as assets and liabilities on their balance sheet. Prior to the new standard, a lessee did not recognize assets and liabilities arising from most operating leases. Although the effective date of the new lease standard is a few years away [effective for public business entities in fiscal years beginning after Dec. 15, 2018, and for most calendar-year private companies to adopt by 2020], Grant Thornton is advising clients to begin their implementation process soon, given the expected time it will take, the need to design or redesign processes and controls, the desire to anticipate and manage the impact on their financial statements and ratios, and the requirement to apply a modified retrospective approach to comparative reporting periods.
Ken Johnson
Partner
KSJG Accounting & Consulting
Irvine
At KSJG, we deal with privately held companies only. As such, we have sent out an email blast with a summary of the ASU 2016-02 update. In addition, we have been talking to each client during each audit about how the update might affect their financial statements. Our plan is to have that conversation throughout this year and then plan for an implementation strategy during the planning of the 2017 and 2018 year-end audits.
The goal is to have that strategy in place well before the end of 2020, which is the required date for private companies. We also will closely monitor the implementation of the public companies for their 2019 year-end requirement and obtain the industry training in the years leading up to those dates.
We are giving a picture to our clients of how their financial statement will look. We want them to understand the new asset that will be appearing on their balance sheet, along with the larger liability related to their operating lease obligations. The issue that comes up is how this will affect the presentation to their lenders in terms of loan covenants. We are starting to discuss this with bankers to get their input. It will be a learning experience for all parties.
By starting now, our intention is to ease the transition for our clients so that the update is simply a change to their financial statements and not a disruption to their business.
Tom LaPlaca
Partner
Moss Adams LLP
Irvine
The most significant changes to accounting for leases are on the lessee side, as few changes were made on the lessor side. Focusing on lessee accounting, the most impactful change is that nearly all leases will be recorded on the balance sheet now as opposed to off-balance-sheet treatment for operating leases, which is how most leases are classified today. Our clients are impacted in many ways, but some of the more important client considerations are as follows:
• The effect on ratios such as leverage ratios, return on assets, performance measures, and tax consequences.
• The impact these changes will have with lenders, particularly the effect on current and future covenants.
• Transition and timing—whether our client is a public or private entity, to ensure a smooth transition companies should start gathering the data required to account and disclose existing leases and capture such data for all new leases they’ve entered into.
• Processes and internal controls—before the changes take effect, process and controls must be properly designed and operating effectively across all functional areas, including accounting, IT, legal, procurement, treasury, etc.
• Consider software solutions to manage lease accounting, as traditional spreadsheets may no longer be adequate due to the calculations of lease assets and liabilities at each reporting period.
Moss Adams is ramping up by making sure our professionals are properly trained, and understand the differences between the historical lease accounting and the new guidance. This includes the impact it will have on clients’ financial statements and how such may impact lease vs. buy business decisions as well as any necessary changes to systems, processes and controls. Additionally, we have already started the conversations with clients to make sure they are well positioned for a smooth and orderly transition and to provide them with the necessary information to decide if early adoption is desirable. We’ve published a guide to assist clients with understanding the more significant areas of the new accounting standard that is available at the Moss Adams website.
Kim Letch
Managing Partner
Ernst & Young LLP
Irvine
The new leasing standard significantly changes the accounting for leases and could have far-reaching implications for many companies.
Lessees will be required to put most leases on their balance sheets while recognizing expenses on their income statements in a manner similar to existing accounting standards—essentially adding both assets and liabilities to the balance sheet. For lessors, the new guidance modifies the lease classification criteria and the accounting for sales-type and direct financing leases.
The new guidance eliminates existing real-estate-specific provisions for all entities. Many of the provisions in the new standard require significant judgment and planning, particularly in arrangements that include substantial services.
While the new leasing standard won’t take effect for public companies until 2018, the time to start preparing is now. We are proactively working with our clients to provide them with the resources and guidance they need to navigate these terms and achieve successful implementation.
Kellan McConnell
Senior Manager, Assurance Services
Marcum LLP
Irvine
The new lease accounting standards will require organizations that lease assets—essentially all organizations—to recognize on the balance sheet the assets and liabilities for the rights and obligations created by those leases. We’re looking at this mainly from a lessee standpoint, since the rules for lessors are largely unchanged.
Essentially, our approach with each of our clients will be to first educate them on the basics of the new standard and then help them to interpret the details as it pertains to their specific business.
While there is still some time for our clients to prepare before these updates are required to be implemented—basically, fiscal year-end 2019 for public companies and fiscal year-end 2020 for private companies—we are encouraging our clients to adopt these changes sooner rather than later for a couple of reasons:
• The updates are required, not optional, so they will have to change one way or another. For entities with many leases, the process of recording the asset and related liability for each lease may not necessarily be straightforward and may require significant time to research and record properly.
• Understanding the accounting impact of these changes on clients’ financial statements will allow them to assess how it may impact financial covenants imposed by lenders. For some entities, high-balance sheets will look completely different once the new standard is adopted. If they know what these impacts will be sooner rather than later, they will have more time to negotiate new covenants.
Dennis Parrott
Managing Partner
KPMG
Irvine
Earlier this year, the Financial Accounting Standards Board issued new lease accounting rules, requiring companies to move most of their operating leases onto balance sheets effective as early as Jan. 1, 2019. Implementing the new leasing standard can be a huge undertaking, especially for companies with thousands of operating leases sourced from multiple locations. Leases will need to be identified, abstracted, analyzed, entered into a system, validated, and monitored throughout the lease term as they are accounted for—a series of exercises that will take significant time and resources.
We’re advising clients not to delay their assessment of the standard’s impact on their financial reporting and operations. Although the adoption deadline is a few years away, companies will need to properly identify existing gaps and prepare to report several years of leasing data to effectively comply with the standard’s requirements. We’re also advising clients to employ a lease inventory system as soon as possible to capture the key data required under the standard and assemble a cross-functional team to understand broader organizational impacts.
KPMG’s holistic, cross-functional approach to implementing the leasing standard helps clients with their accounting, tax, internal controls, processes and systems changes. We also have combined our accounting experience with IBM’s technology platform to offer a distinct cloud-based solution, KPMG Leasing Tool for IBM TRIRIGA, to help them comply with the new leases standard.
Wayne Pinnell
Managing Partner
Haskell & White
Irvine
The new lease accounting standard dramatically shifts the landscape in financial reporting by changing a long-standing practice where operating leases were disclosed as commitments in the footnotes. The new standard essentially treats leases for property and equipment of a finance or operating nature as an asset and related liability that must be recorded on the balance sheet.
With public company implementation dates for this standard in 2019 (with retrospective treatment to as early as 2017), there is a lot of education and information gathering that should be under way as soon as possible. Private companies have an extra year in this process, but they should give early consideration to the underlying complexity of this project.
Our firm is actively educating our staff, clients and members of the community on the challenges this standard will bring to the classification of leases and the related evaluation of the underlying assumptions, such as the term, lease options and the components of the lease payment structure. An additional complexity is that leases may be embedded in other service agreements that will need to be identified and accounted for separately, an area that will likely catch many by surprise. All in all, companies are likely to underestimate the time and resources that will be needed to locate all of the relevant leasing documents—especially if they have disaggregated operations—evaluate the number of assumptions that must be made, and determine the effects on their financial reporting.
Further education will be needed for users of the financial statements, such as investors, banks and other business partners. The effects of this standard will result in significant changes in financial ratios and presentation that could affect how financial statements are understood, contracts are negotiated and financial analysis is performed for transactions.
Jodi Ristrom
Partner
HMWC CPAs & Business Advisors
Tustin
The new accounting requirement for leases will significantly affect our clients. HMWC CPAs and Business Advisors is proactively implementing a step-by-step approach to ready our clients for the implementation date of fiscal years beginning after Dec. 15, 2019.
The first step is go to through each of our GAAP reporting clients and access the impact of recording the right-to-use asset and liability on their financial statements. A majority of our clients have credit agreements that contain debt covenants. The new liability, which was previously an off-balance sheet activity, may have a significant impact on the debt covenants. Therefore, the second step is to discuss the upcoming GAAP reporting requirement to the client’s banker and how the new regulations will affect the financial statements and debt covenants.
This proactive approach will provide the client time to renegotiate the lease terms and bank covenants, if necessary.
Robert J. Schlener
Partner
SingerLewak LLP
Irvine
When the new rules take effect, leases that previously were not reflected on financial statements will suddenly show up on the balance sheet, creating a significant risk of unintended consequences.
In order to achieve the best possible outcome, we are already engaging clients and prospective clients to assess their leases, both before and after they are executed.
Much can be done now to restructure leases, seek new leases with more favorable terms, or simply understand whether the accounting changes will materially affect their financial position.
Brian Tunnelle
Partner
Frazer LLP
Brea
With its issuance earlier this year, the new standard on lease accounting is finally a reality. Companies of all sizes will undoubtedly have challenges in complying with the required accounting for leases. Larger companies will have larger and more complicated arrangements to be analyzed, while smaller companies will lack the personnel resources to properly implement.
Most of our clients are reliant on bank financing for short-term working capital, equipment financing and other long-term needs. Also, many of our construction contractor clients perform public works projects, requiring surety bonds. These credit relationships are very much driven by the financial statement covenants of the company.
The new lease standard requires a liability for the lease obligation to be recorded on the company’s balance sheet. Additional “right-of-use” assets also are recorded. This requirement will drastically change the geography of the balance sheets of most companies, impacting the financial covenants imposed by the company’s creditors. So the education we provide over the next few years will not only be to our clients, but also to the users of the financial statements. Companies will need to work with their creditors in advance to modify financial covenants to align with the new accounting this standard requires.
Our firm’s segment of the middle market, comprised of closely held and family-owned businesses, will lean on our firm to guide them through these new accounting requirements. Additionally, many will have us assist in the interactions with their creditors to make sure their covenants are reasonable and achievable.
As this new pronouncement has been years in the making, we have been consistently watching this topic and its impact on our clients; however, over the next few years we will have multiple trainings covering all levels and departments to help our clients evaluate and implement this new standard. As with many of the far-reaching pronouncements issued by the Financial Accounting Standards Board over the past 15 years, this presents our firm an opportunity to proactively consult with our clients and take steps to improve their financial reporting as they transition into the new lease standard.
Gretchen Valentine
Office Managing Partner, Tax Services Partner
RSM US LLP
Irvine
RSM is focused on serving middle-market companies. Many companies that have traditionally entered into operating leases could be significantly affected by the requirement to recognize right-of-use assets and lease liabilities on their balance sheets for all but short-term leases.
Adding these assets and liabilities to the balance sheet could significantly affect the financial ratios a middle-market company uses for various reporting purposes. For example, if a middle-market company has a debt covenant based on its debt-to-equity-ratio, its ability to satisfy that covenant after implementing the new lease guidance could be seriously compromised. It is possible that the only remedy available in this situation may be to modify the debt agreement.
Even though the Financial Accounting Standards Board provided a significantly deferred mandatory effective date for the new standard, RSM is working with its clients to begin familiarizing them with the new lease guidance to better understand its potentially significant financial reporting consequences to the users of their financial statements. We have incorporated this discussion into our client planning meetings.
A white-paper discussion of the new lease rules is posted on RSM’s website for download.
