Leases: Accounting Standards 2016-02

Effective Date

ASU 2016-02 is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years for:

• Public business entities
• A not-for-profit entity that has issued securities on an exchange or over the counter market
• Employee benefit plans that file financial statements with the SEC

For all other entities, ASU 2016-02 is effective for fiscal years beginning after December 15, 2019, and interim periods within fiscal years after December 15, 2020. However, early application is permitted for any type of entity.

Even though effective dates for ASU 2016-02 appear to be far in the future, companies should think about preparing for this new standard sooner rather than later because of FASB’s new revenue recognition. Implementing new procedures for both at the same time can save time and money than implementing one at a time.

Focus

This standard’s main point of focus is that an entity should be recognizing assets and liabilities coming about from a lease. This standard eliminates the old distinguishable characteristics between an operating, or off-balance sheet, lease and a capital lease. Leases are now either categorized as finance, operating, or short-term. Short-term leases are ones that have a term of 12 months or less and does not include an option to purchase the asset; therefore, it falls outside the scope of ASU 2016-02 and do not have to appear on the balance sheet unless they include extension options that are “reasonably certain” to be exercised. An entity must determine the classification of the lease on the lease commencement date, which is the date the lessor makes an underlying asset available for use by the lessee.

Under the new guidance, a lessee must record the following items for all leases, regardless of whether they are designated as finance or operating leases:

• A liability for lease payments (referred to as the lease liability); and
• An asset for the right to use the leased asset during the lease term (referred to as the right of use asset).

ASU 2016-02 states that something can only be considered a lease if there is a right to control the use of an identified property, plant, and equipment. With that requirement, ASU 2016-02 does not apply to leases of intangible assets, exploration or use of mineral, oil, and natural gas, biological assets, inventory, and assets under construction.

Review Debt Covenants

Due to this new standard, debt covenants will have to be reviewed because ASU 2016-02 may be impacting them. Some examples of covenants that will impacted are Debt to Equity Ratio, Total Debt Less Than $XX, Return on Assets, and Tangible Net Worth Covenants. Also prior to the standards changing, negotiating with the bank is a very good option. Some examples of items that could be negotiated are for debt covenants to be calculated with “frozen GAAP”, including a clause excluding the operating lease liabilities from the definition of liabilities in the borrowing agreement, or indicating that “Right to use assets” are not included in the definition of intangible assets.

Example of operating lease previously expensed