Why New Lease Standards

The lease standard stems from concerns financial statement users and the SEC voiced regarding the lack of transparency related to material lease obligations that have been reported off-balance sheet. Under the new lease standard, leases will appear on the balance sheet as both a right to use asset and a lease payment liability. All leases with a maximum term longer than twelve months will be capitalized on the balance sheet. As a result, users of financial statements will be presented with a more accurate picture of the long-term financial obligations of companies.

Lease Categories

The new lease standard considers there are two types of leases, Type A and Type B. Type A leases include most non-property type leases and are effectively an installment purchase and is consistent with what is now known as a capital lease, while Type B includes mostly real estate leases and are typically what are now known as operating leases. The category a lease falls into will have important implications on financial statements. Lessor accounting for Type A leases will require capitalization of lease receivables and de-recognition of the underlying assets. For the lessee in a Type A lease, more interest expense will be incurred in the earlier periods, as compared to a Type B lease that utilizes the straight-line approach.  Front-loaded interest expense plus constant amortization expense will have a greater impact on the income statement at the beginning of the lease term for Type A, while the impact of a Type B on the income statement will remain constant through the lease term. In regards to your statement of cash flows, Type A leases are included within financing activities, and Type B lease payments are recorded under operating activities.

Taking Action

The new lease standard will increase faithful representation of a company’s financial obligations and assets used under lease arrangements and, therefore, lead companies to better reflecting their financial condition, but also make companies appear deeper in debt. CFO’s are going to have to be prepared to explain to shareholders why debt seems larger. Increasing levels of debt on the balance sheet could also cause companies to violate debt covenants, and now is a good time to review lease agreements to assure you will remain in compliance or begin negotiations towards restructuring debt covenants.

Contact Jim Krupinski at jkrupinski@dopkins.com if you would like further information.

About the Author

James A. Krupinski CPA

Jim has 25 years of experience providing audit and consulting services to clients from a diverse range of industries. In addition to his many audit management responsibilities, he currently serves as the leader of the Firm's risk management services group. He has assisted his clients with performing risk assessments, evaluating and improving internal controls, developing fraud prevention programs and complying with the requirements of Sarbanes Oxley's assessment of internal controls over financial reporting requirements.