More than two years ago, new Accounting Standards went into effect that impact the accounting treatment of leases – yet businesses and nonprofits are still navigating this major change.

The new accounting standard affects all organizations that lease real estate, vehicles, equipment, or other assets for more than one year. Previously, operating leases were considered “off” balance sheet, which meant they only had to be disclosed in the financial statement footnotes. This made it hard to identify future debts that could reflect significant financial liabilities.

As a result of Accounting Standards Update (ASU) No. 2016-02 that took effect in 2022, lease obligations longer than 12 months must now be reported on the balance sheet as a right-of-use (ROU) asset and lease liability. The intention is to improve transparency and provide a more accurate measure of the contractual obligations that underlie leases.

More Consistent Representation

With the new lease accounting standard, financial statement users benefit from a more consistent representation of lease obligations. It’s now easier for users to understand the amount, timing, and uncertainty of cash flows related to leases.

All operating leases must now be recorded as an asset and a liability on the balance sheet. The ROU asset must be amortized over the life of the lease while an offsetting liability for the present value of the lease payments must be recorded. This represents the obligation to pay the lease.

According to the right-to-use concept, an operating or finance lease contract gives the lessee the right to control the use of an asset for a certain time period. This right creates an asset that must be reflected on the balance sheet, along with a corresponding recognized liability.

Note that short-term leases of 12 months or less and leases for intangible assets (such as computer software) are not subject to the new lease accounting standard.

Important Points

Here are a few things to keep in mind in adjusting to the new lease accounting standard:

• The standard creates a new lease definition: “A contract or part of a contract that conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration.”
• The standard also creates a new lease term: the noncancellable period during which a lessee has the right to use an underlying asset. This term should be based on the period during which the contract is enforceable.
• Because operating leases now create a lease liability and ROU asset on the balance sheet, it’s important to review all service agreements and contracts to see if they contain an embedded lease. If so, the lease must be accounted for using the new standard.

Impact of the New Standards

The new Standards are significantly impacting organizations with long-term leases. The additional debt and leverage added to the balance sheet is affecting lenders’ financial ratios and metrics. This could affect debt covenants so it’s important to talk to lenders about the potential impact.

In addition, because off-balance-sheet financing under U.S. GAAP was one of the main benefits of leasing, the curtailment of this type of accounting structure is altering the lease vs. buy decision for organizations. In some instances, asset purchases could be more attractive than they were in the past.

Eliminate Confusion

In order to provide clarity and in the interest of full transparency, lenders, board members, funders, and other stakeholders who reference financial information and reports should be informed of how leases are shown on financial statements.

Dembo Jones is available to help you better understand this new lease accounting standard, and how it impacts your business or not-for-profit. Get in touch with us today.