Changes to lease accounting rules impact business financial statements and due diligence inquiries in sales and dispositions of businesses.
The traditional financial statement would have finance leases and capital leases that users of financial statements would be able to interpret having some familiarity with the established concepts.
What is now considered a lease?
Now, under the new rules from FASB and IASB, a lease is the right to control and use an asset for a period of time in exchange for payment(s) and this creates an asset and a liability that lessees must put on their balance sheets. The new rule recites that a lease exists if there is control such that one has the right to operate, control physical access or take all of the output from the asset. Now, due diligence activity must review contracts to determine if a lease is present. The right to substitute defeats the right to control a particular asset that is essential for a lease.
The new rule will probably force many capital leases to be classified as finance leases, where the right to use will be amortized by the lessee who must also recognize an interest component. Most operating leases will probably remain classified as such.
Changes the new rules bring
One change is that sale and leaseback transactions must conform to the revenue recognition model under ASC 606 Contracts With Customers. This will change how sales are recognized in a sales and leasebacks.
Leases with bundled services must be divided into interest expense and lease expense. Variable rate payments must be measured at the start of a lease. Variable use payments are recognized as incurred by the lessee and as earned by the lessor.Under FASB, lessors will recognize profit at the start of the lease when it is essentially a sale and over the term of the lease if the lessee does not obtain control. Leveraged leases accounting is eliminated. Lessors will recognize income at the start of the lease under IASB rules in either instance.
The new rules come into effect for private clients in the years after 2019, although early adoption is permitted.
Problems with the changes to lease accounting rules
There are a few problems that one can expect. First, older accounting software may not adapt to the new rules and this raises questions about financial statements and their evaluation. A bridge or conversion statement may be necessary to evaluate historical information under the new rules.
Compensation benchmarks, loan covenants and other metrics can be impacted by the new accounting rules. How does someone performing due diligence evaluate the credit worthiness or earnings capacity under the change without modeling the target? Lenders will be impacted by these rules and may want to re-negotiate covenants for this reason. Finally, executive compensation will undoubtedly be the subject of careful analysis.
Are you still unsure about these changes to lease accounting rules? Would you like to discuss the matter further? If so, please contact me, James McDonough, at 201-806-3364.
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