Most entertainment and sports-related companies today are engaged in some form of leasing activity. This would include the leases they sign for their office space, cars for their executives, video monitoring equipment, desks and chairs – you name it. Leasing has become a fundamental component of today’s business operations.
The New Standard: Recognizing Operating Leases on Balance Sheets
As most CFOs already know, under the current accounting model, their organization applies a classification test to determine the accounting methodology to be used for a lease arrangement. Some leases are classified as capital leases (for example, a lease of equipment for nearly all of its useful life). Capital leases require the lessee to recognize its lease assets and liabilities on the company’s balance sheet. Other leases, such as the long-term lease of office space, are classified as operating leases. Lessees are currently not required to recognize operating lease assets and liabilities on the balance sheet.
For years, there was widespread criticism that this operating lease model was deficient in meeting the needs of financial statement users because it did not always provide an accurate representation of leasing transactions. Enter the Financial Accounting Standards Board, known to us accountants as FASB.
Last February, FASB issued updated accounting standards designed to improve the financial reporting of assets and liabilities that result from a company’s leasing activities. The new lease accounting standards, which have been under consideration for a decade, will require lessees to present the results of most leasing activities directly on their balance sheets instead of in the footnotes to financial statements.
All companies reporting under International Accounting Standards Board (IASB) or FASB will need to comply with the new requirements.
What You Should Do Now
Companies need to start thinking through the potential impact of the new standard. This is especially important because the standard must be applied retroactively to previously issued financial statements. For some companies, the new lease accounting standard will require widespread modifications to the processes and systems they currently use to account for leases. This could alter management’s data requirements, measurements, and judgments.
It is also critical to understand the potential impact on financial covenant calculations. In many cases, bringing these leases to the balance sheet will have a significant impact on the company’s leverage ratios.
Here are five pre-implementation steps we are advising our clients to undertake in preparation for the new lease accounting standard:
1. Take inventory. Understand which of your agreements have lease components. This could include the leasing of film equipment, software, trucks and trailers, real estate property, etc. Knowing the volume of leases that must be evaluated will be the first step in determining the scope of the work that needs to be done. This may help your company decide if it needs to outsource the evaluation and organization of the effort or if it can handle things in house.
2. Determine the classification of each lease agreement. Are your leases classified as an operating lease, a finance lease, or a short-term exception?
3. Gather data for your lease calculations/ document your accounting policies. A number of accounting policy determinations will be related to how lease calculations are completed. Adopting certain practical methods can save time and manpower. Also, evaluate how discount rates may impact the calculation and how your company will handle option periods.
4. Calculate Lease Recognition. Calculate the right to use asset, as well as lease liability, on your balance sheet. Determine the lease cost, and/or any interest/amortization on your income statement.
5. Understand the impact on your financial statements and other agreements. This includes changes to your balance sheet such as increases in assets and liabilities. Higher levels of disclosures will require organizations to identify the nature of leasing transactions, the lease’s rights and obligations, the assumptions and estimates used by management, and a summary of maturities. It is also critical to understand the potential impact on financial covenant calculations. In many cases, bringing these leases to the balance sheet will have a significant impact on the company’s leverage ratios. Adoption of this standard will also impact companies’ EBITDA calculations. Have upfront discussions with your lenders on the new leasing standard to ensure that there is no confusion once it is in place.