Accounting standard change will affect how private companies report real estate and other leases

Over the past two years, many private company financial services have been busy accounting for funding for the Paycheck Protection Program amid the pandemic.

This year, these companies – and their accounting firms – will be busy tackling a new challenge: complying with new Financial Accounting Standards Board (FASB) guidelines on leases that, for the first time, require all private companies to recognize operating lease assets and liabilities on their balance sheets.

The new rental standard is designed to create greater transparency around the company’s finances, said Michael Sabol, partner at Glastonbury accounting firm Mahoney Sabol & Co. Under the previous standard, only capital leases had to be recorded on a company’s balance sheet, while operating leases were mentioned in footnotes.

For accounting purposes, a capital lease is similar to owning an asset, even if it is leased for a period of time, while an operating lease is more like the leasing of a property.

The change is part of a broader, multi-year evolution of standards aimed at bringing the country’s generally accepted accounting principles, or GAAP, more in line with international accounting standards.

Public companies were required to comply with the new rental standards in 2020. As of December 15, 2021, the change now applies to all private companies. Although the change is not yet required for quarterly financial statements, private company balance sheets must comply by the end of 2022. Original leases of less than 12 months do not apply.

“Yes [a company]takes out a loan to buy a printer and pays it off at $1,000 a month and [another company]leases the printer for $1,000 per month, they have the same liability for the asset,” Sabol said.

Under the old rules, however, only the first company would have shown this expense on its balance sheet; now both are treated the same.

“It has no effect on the economics of the company because they always pay a certain amount for the rental of the asset,” he said. “But it’s going to have a big impact on companies’ financial statements.”

For many companies, this increase in liabilities could impact bank covenants and loan agreements, which are factored into a company’s debt ratios to set terms. Companies may be in breach of their covenants depending on the definition of debt in the loan document, but the FASB allows operating leases to be characterized as “operating liabilities” rather than debt.

“This change can have significant ramifications on a business’s loan documents, so it’s good for customers to have a conversation with their bank early on,” said Don Bidwell, head of financial accounting and advisory services for accounting firm Marcum LLPwhich has offices in Hartford and New Haven.

Starting this process early is important, Bidwell said, because identifying all of the operating leases that need to be accounted for can be a challenge.

“People usually think of the office space or the piece of equipment they’re renting,” Bidwell said. “But there might be something in a service contract that could be considered a lease.”

Tim Kolber, Managing Director of Accounting Advisory and Transformation Services at Deloitte, said the new normal impacts all facets of an organization.

“It’s not only [an impact]from a financial perspective,” Kolber said. “People in the legal and procurement department or anyone who might interfere with a lease should [be part of the process].”

As a result, more companies are turning to technology, with nearly 40% of companies using artificial intelligence and machine learning to comply with the norm, according to a recent survey by the global human resources company Robert Half. A similar percentage (41%) expect to rely more on advanced technologies in the coming years, according to the survey.

As time ticks toward the Dec. 31 deadline, Kolber said companies looking to implement technologies should begin soon.

“It’s not as simple as setting up home accounting software,” he said, noting that between selecting, installing and testing the technology, it could take three at five months.

This change also comes at a time when many companies are assessing their office space needs in the midst of a remote or hybrid workforce.

The International Accounting Standards Board estimates that adding real estate leases — for U.S. public and private companies combined — under this new standard could collectively add nearly $3 trillion in liabilities to balance sheets.

This may prompt some businesses to adjust existing leases or sign shorter-term leases in the future.

Sabol, of Mahoney Sabol & Co., said the understanding of what constitutes a real estate lease is also changing. He cites, as an example, a hospital affiliation, where one hospital may have space available in another to carry out work.

“In certain circumstances, under the new standard, this could be considered a [reportable]rent now,” he said.

Bidwell, of Marcum, said he has seen a steady increase in the number of clients who are beginning to focus on preparing for the new accounting standard on leases.

“It’s always easier to do it sooner than later,” Bidwell said.

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