A lot will change in lease accounting starting in 2019. From January 1, 2019, the Financial Accounting Standards Board (FASB) and the International Accounting Standard Board (IASB) will have new standards, ASC 842 and IFRS 16 respectively. What is lease accounting? And what exactly is going to change?
You can either buy or rent buildings, land, cars or other assets. While it used to be the norm that organizations bought everything, from facilities to photocopiers, the capital expenditure or the long-term financing needed for this approach was one of the reasons that organizations grew slowly. An owned asset was also not very flexible.
In the 1980s and 90s the trend changed to rent rather than buy, for a number of reasons. It meant that organizations no longer needed to save or go to the bank for a loan, but that they could simply lease what they needed. The money saved could then be invested in the primary business, for example by hiring new staff or investing in R&D.
This yielded more profit than the annual returns from purchased assets. The name that is given to this is “off-balance financing”. Companies no longer had major debts and possessions on their balance sheets, but financed through sale and leaseback.
However, shareholders and accountants then felt the need for clarity and realistic figures. The accounting world therefore decided that a multi-year rental obligation (or lease) should in fact be regarded as a debt, and should therefore be reflected as such on the balance sheet. When a leasing contract is included on one side of the balance sheet, the right to use the premises should appear on the other side. This gives the shareholders and the accountant a far better insight into the actual value and debts of an organization. This is the principle of lease accounting.
Starting January 1, 2019, publicly traded companies will be required to include on their balance sheets all their leasing contracts with a contract term longer than a year.
This process began a few years ago by the FASB and the IASB. These bodies have the authority to create standards, and to hold organizations to them. More than a thousand proposed amendments were submitted for the new standards, which took time to review and incorporate. The result? New standards based on the input from the professional field.
From January 1, 2019, exchange-listed companies will have to start listing their leasing contracts in the balance sheet, as well as the way in which both the obligation to pay rent and “ownership” of the right to use the asset will be calculated and reported regularly.
This will not make leasing less attractive to organizations, given that the principle remains unchanged: buying buildings produces little return (3% to 4%). Although a rental contract is currently shown on the balance sheet as a debt, the money released continues to be available to invest in the primary business. The margins on production are often many times greater, enabling an organization to increase its profit. The new standard simply gives a more honest picture of an organization’s financial situation.
The new lease accounting standards not only will impact operational management, but they also will offer new opportunities. I will elaborate on this in my next blog.
