New Lease Accounting Standards Arrive
How this long-awaited guidance might affect your dealership
In 2006, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) launched a joint project designed to change the way leases are accounted for under U.S. Generally Accepted Accounting Principles (GAAP).
A decade later, the FASB has finally issued new guidance for lease accounting. Accounting Standards Update (ASU) No. 2016-02, Leases (Topic 842), will require dealerships that lease real estate, vehicles, equipment and other assets for more than one year to report lease obligations as fixed-asset liabilities on their balance sheets. Most lease obligations today aren’t listed on the balance sheet – in fact, financial transactions are often structured to achieve off-balance-sheet treatment, because this improves ratios and strengthens the bottom line, making it easier to obtain financing.
The effective date for the new standard for nonpublic entities doesn’t kick in for a few years, but early adoption is permitted.
From an accounting standpoint, leases are classified as either capital leases or operating leases. Historically, dealerships have only been required to recognize capital leases on their balance sheets. Operating leases, including long-term leases of your dealership’s real estate, could be listed as a footnote in the financial statements detailing the terms of the lease agreement, and payments were recorded as rent expense.
The new lease accounting standard will change the accounting treatment of leases that are longer than one year in duration. Your dealership must recognize on the balance sheet assets and liabilities for all such leases, regardless of whether they’re classified as capital or operating leases. Under the new standard, you’ll report a right-to-use asset and corresponding liability for the obligation to make lease payments, discounted to their present value.
The new standard will classify leases as either finance leases or operating leases. The differentiating criteria will be similar to the criteria used to distinguish between capital and operating leases. Finance leases will be similar to capital leases under U.S. GAAP – in fact, most current capital leases will be considered finance leases under the new standard. The recognition, measurement and presentation of expenses and cash flows arising from a lease will continue to depend mainly on the capital (or finance) vs. operating lease distinction.
For capital leases, your dealership will amortize the right-to-use assets separately from interest on the lease liability on the statement of comprehensive income. You’ll classify repayments of the principal portion of the lease liability within financing activities, and you’ll classify interest payments on the lease liability and variable lease payments within operating activities in the statement of cash flows.
For operating leases, you’ll recognize a single total lease cost that is calculated so that the cost is allocated over the lease term on a generally straight-line basis. All cash payments, meanwhile, will be classified within operating activities in the statement of cash flows.
Impact on dealerships
There are several ways the new lease accounting standard could impact your dealership:
- The addition of more debt and leverage to your balance sheet could affect key financial ratios, so you should communicate with lenders, investors and other stakeholders in advance to let them know about these upcoming changes.
- Similarly, changes in financial ratios could impact debt covenants with current lenders, or make it more difficult or expensive to qualify for financing in the future – something you’ll want to discuss with your lenders ahead of time so they’ll be prepared.
- You may incur additional costs to train employees in the proper application of the new standard.
Finally, the new lease accounting standard could significantly impact your future lease vs. buy decisions. The ability to structure off-balance-sheet financing under U.S. GAAP is one of the main benefits of leasing. With this benefit curtailed, buying certain assets might become more attractive.
Effective dates and deadlines
Privately owned dealerships must adopt the new lease accounting standard for fiscal years beginning after December 15, 2019, and for interim periods within fiscal years starting after December 15, 2020. If your dealership is public, the standard is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years.
Dealer Insights - July-August 2016