Accounting update: A new home for operating leases
The Financial Accounting Standards Board (FASB) will begin requiring operating leases to be recorded on the balance sheet in 2019. RSM partner Joel Steinberg discussed the rule’s impact on the financial services industry at RSM’s ninth annual Investment Industry Summit on Sept. 19, 2017.
Historically, accounting standards did not require operating leases to be recorded on the balance sheet. Lease payments were reported as expense. Thus, a large liability was thus left off the balance sheet.
Leases will go on the balance sheet
FASB’s new standard, ASC 842, requires all leases to be on the balance sheet with the exception of very short-term leases, typically of less than a year.
Even if a lease is shorter than a year, it might need to be on the balance sheet if renewals are likely. Without such a provision, an entity could avoid capitalizing its leases by renewing year to year.
How it works
1) A lease liability is set up for the present value of the unpaid lease payments.
2) An asset for the same amount, called a “right of use asset,” is recorded at the same time.
Initial costs and lease incentives might go into the equation.
The lease liability will diminish as it’s paid—in effect, as it’s amortized—and the right-of-use asset will be amortized as well.
The asset and liability will initially be the same. Depending on the method of amortization, they may or may not match exactly going forward. The rule provides an option to have them match.
Operating lease vs. capital lease
Presentation on the income statement will be different for the two basic types of leases: operating leases and capital leases involving financing.
With an operating lease, profit and loss will include the amortization of the right-of-use asset (i.e., the rent expense).
For capital leases, the rules remain essentially the same as they are today. Lease payments and interest expense are both recorded on the balance sheet.
Impact on capital requirements, loan covenants
For broker-dealers, putting a new liability on the balance sheet theoretically could negatively affect net capital requirements and measures of aggregate indebtedness, because for regulatory purposes the right-of-use asset unallowable. However, the Division of Trading and Markets of the Securities and Exchange Commission issued a no-action letter on Nov. 8, 2016, stating that adjustments would be permitted. Companies will be allowed to exclude an operating-lease liability from its aggregate indebtedness and to include the lease asset in net capital.
Entities with loan covenants that rely on measures of liabilities should discuss the new standard with their lenders. They may need waivers initially and may need to modify the covenants going forward.