In February 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update No. 2016-02, Leases (Topic 842) (the Update). The Update represents the first comprehensive overhaul in lease accounting in approximately 40 years.
Although the Update is not effective until fiscal years beginning after Dec. 15, 2018 for public companies (fiscal years beginning after Dec. 15, 2019 for non-public companies), stakeholders should be aware of the key changes, as they will have a significant impact across all industries, including the transportation industry. When effective, the Update will supersede the current lease accounting standard (Topic 840).
The FASB spent several years working on the lease accounting project. The project was in response to an overall feeling that the current lease accounting model, which is driven by a bright-line test, was broken and leads to inconsistencies in accounting for similar transactions. For example, a similar lease agreement could be recorded as an operating lease by one entity, thereby not impacting the balance sheet, whereas another entity may record it as a capital lease, thereby recording a leased asset and lease liability on their balance sheet.
The key difference between the current standard and the Update is the recognition of a right of use asset and a lease liability on the balance sheet for those leases previously classified as operating leases. In other words, all leases will be recorded on the balance sheet. One caveat is that the entity can make an accounting election to not apply the guidance to short-term leases (leases less than 12 months). Leases will be classified as either a finance lease (replacing the term, “capital lease”) or an operating lease.
For finance leases, the income statement treatment is similar to today’s capital leases. For operating leases the income statement treatment is also similar to today’s operating leases. While both lease classifications will require the leased asset and liability to be presented on the balance sheet (at the present value of the future required lease payments), the income statement will essentially be unchanged from today’s lease accounting standard.
It is important to note that lessor accounting will essentially be unchanged from the current lease accounting standard, although lessors will need to consider and understand the new revenue recognition standard’s impact.
The classification between a finance lease or an operating lease will be determined very similarly to today’s bright-line test. To classify as a finance lease, a lease must meet one of the following criteria:
- The lease transfers ownership of the underlying asset to the lessee by the end of the lease term, or
- The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise, or
- The lease term is for the major part of the remaining economic life of the underlying asset (generally assume 75 percent or greater), or
- The present value of the sum of the lease payments and any residual value guaranteed by the lessee equals or exceeds substantially all of the fair value of the underlying asset (generally assume 90 percent), or
- The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.
If the lease agreement does not meet one of these criteria, then the lease is recorded as an operating lease.
The Update will likely have a significant impact on the presentation of most trucking company financial statements and could also impact bank covenants and buy versus lease decisions. The most significant and obvious impact is for those companies that generally lease their revenue equipment pursuant to operating leases. Today, the leased asset and lease liability are not presented on the balance sheet. When the Update is in effect, the company will have to record both a leased asset (right of use asset) and lease obligation. This could significantly impact financial measures such as working capital and current ratio. However, it was not the FASB’s intention (see FASB’s Background Information and Basis for Conclusions) for the operating lease liability to be considered “debt.” As a result, adding an operating lease liability to the balance sheet should not impact debt/equity ratios, debt service ratios, etc.
There are many other factors to consider when implementing the Update that are not addressed in this article, including the lease term, lease payment considerations, financial disclosures, and the transition itself. As noted above, it is important for stakeholders to understand the Update and begin to educate the users (management, lenders, customers, etc.) of their financial statements. This should include taking an inventory of existing leases. It may also be helpful to provide pro-forma financial statements when necessary. Additionally, it is important to understand debt covenant requirements, and be sure that your banks understand the FASB’s intent of not classifying operating leases as debt. The more time spent up front understanding the Update, the easier the transition will be for all.
About the author:
Jason Miller is a partner in Katz, Sapper & Miller’s Transportation Services Group, which specializes in transportation law. Jason focuses on the day-to-day delivery of core KSM services, including financial statement audits, reviews, and consulting. Connect with him on LinkedIn.