If your business deals with leases, your team needs a good grasp on the new lease accounting standard relevant to you. As of January 2022, businesses must keep in-depth records for leases to stay compliant. The old standard faced criticism for not requiring sufficient information about a company’s leasing transactions, allowing room for various interpretations. In response, the FASB issued the Accounting Standard Codifications 842- Leases to address these concerns.
In 2006, the International Accounting Standards Boards (IASB) and the Financial Accounting Standards Boards (FASB) agreed to prioritize the convergence of lease accounting. At that time, many prominent businesses leveraged loopholes in the old standard lease agreements to keep them off the balance sheet, to skew financial ratios in a more favorable direction. Because of this abuse, the SEC sent a letter to the FASB (US Financial Accounting Standards Boards) and IASB (International Accounting Standards Board), asking them to act and develop a standard that more accurately reflects a company’s true liabilities.
At this point, the SEC, the FASB, and IASB initiated a joint project to develop a new lease standard. Still, they parted ways in 2016 due to differing opinions on whether to maintain lease classifications (operating versus financing) in the new standard.
Under the old standard, only capital leases were seized on the balance sheet, while operating leases were on an off-balance sheet, reflected only in P&L (Profits and Loss). There were strict thresholds (Bright lines) that clearly classified each lease as operating versus capital.
This definitive classification allowed companies the ability to structure lease agreements to qualify as operating leases when they, in substance, are more closely aligned to a capital lease. Thus, financing the acquisition of assets through debt. By classifying these leases as operating, companies kept the future lease obligations off the balance sheet, which masked their true liabilities and made key ratios appear more favorable.
The new standards now require virtually all leases to be reflected on the balance sheet. A “lease liability” is recorded at lease commencement, and a new “right of use” (ROU) asset account is introduced for all lease types. The resulting change has the biggest impact on what were previously operating leases. Depending on the size and quantity of the leases, the company’s total assets and liabilities will be higher than in prior periods.
Deciding how to apply and account for the new standard is complicated and will take more than simply changing some lines on a spreadsheet. The new standard could add significant amounts to both sides of the balance sheet that were not there before. This change could directly affect financial ratios related to banking agreements and force additional analysis for future considerations regarding buying versus leasing equipment. If you need assistance, please contact us, Arias Leonor Accounting Services. Consult with us today!