With the effective date of the Financial Accounting Standards Board’s new lease standard quickly approaching, virtually all companies will be required to evaluate the potentially significant impact of the standard on their individual financial reporting posture.
Set to take effect Jan. 1, 2020 for calendar year-end nonpublic entities, ASC 842 requires lessees to recognize an asset and liability on their balance sheet for all leases with terms greater than 12 months, including operating leases. The new standard introduces an additional level of complexity with the changes in the definition of a lease: Certain arrangements previously considered leases may no longer be accounted for while others, such as implicit leases, are being reevaluated to determine if they qualify.
The standard affects practically all companies that have a right to control the use of an identified asset, which includes office space, vehicles or other equipment. While industries that typically hold numerous equipment and real estate leases are expected to be significantly impacted, entities with few leases will need to comply with the new standard and consider its implications.
There are substantial challenges accounting teams may face as they begin implementation, including whether a software solution should be implemented to assist with ongoing tracking and accounting of leases, obtaining a complete population of leases, and the impact on internal controls.
The new lease standard may also have a significant impact on key metrics companies report to their investors as well as on the company’s debt covenants. Investors, analysts and lenders may need to reassess their models around key performance indicators, cash flow and capital expenditure.
If decisions are made to migrate from a lease to a buy posture, the direct or indirect impact of ASC 842 may include commonly used financial indicators, such as leverage ratios, debt covenant ratios and borrowing costs, return on assets, regulatory capital requirements, book/tax differences, performance-based compensation/ EBITDA earn-outs and other metrics. Other areas potentially impacted include bonding capacity, credit ratings, enterprise value, gearing ratios, liquidity, purchase agreements and working capital.
During the transition to the new standard, investors and lenders will continue to consider whether to treat the on-balance sheet nature of operating leases as capital expenditures and debt, or simply to adjust the leases to mirror current practice.
While these changes do not directly change total cash flows, they may have an indirect impact as a result of changes in buying versus leasing. Entities should thoughtfully consider the impact new leases and/or amendments may have under the new standard, and how it may affect their financial results and accompanying disclosures, processes, controls and other areas of the business, as well as the impact on potential transactions.
Caleb Vuljanic is a partner in DHG’s Private Equity and Assurance Services practice.
Dustin Hamilton is a director in DHG’s Private Equity and Transaction Advisory Services practice.