For as long as most of us can remember, real estate leases were always reflected in financial statements as an operating expense. Every rent check was simply expensed. There was no discussion of recording assets or liabilities. Things are about to change.
In 2016, the Financial Accounting Standards Board (FASB) created new lease accounting standards. The change will be effective for years beginning after December 15, 2018 for public business entities and December 15, 2020 for all other entities. (Dates updated October 18, 2019) Generally Accepted Accounting Principles prescribed Accounting Standards Codification (ASC 840) that required each lease be reviewed to determine whether it is an operating lease or a capital lease. In most cases, real estate leases were considered operating leases. This allowed for the expensing of lease payments as the monthly liability occurred. It was done based on the concept of risks and rewards of ownership. The new standard as defined in ASC 842 brings a different concept to be used—the right-of-use model.
Based on this model, companies will be required to capitalize all leases that are for longer than one year. An asset will be created with a related lease liability. To decide on the amount to be placed on the balance sheet, it must be determined if it is an operating or a finance lease. A finance lease is basically the new term for capital leases and will be treated much the same way it was under ASC 840. However, for most situations, a lease of real property will fall under the new operating lease rules and will, therefore, require capitalization with a corresponding lease liability.
Under ASC 842, the total cost of the operating lease will be set up as an asset with an offsetting liability. The amount used for the cost will be the total amount of the payments, discounted for an “interest” factor. There will be a corresponding liability that will be similarly net of interest. The monthly payments will reduce the liability with a portion allocated to interest expense. The cost will be expensed monthly as amortization.
These changes will require more accounting work and can affect loan covenants. If you have covenants, a discussion with your banker should be scheduled before this new rule goes into effect.