With calendar year-end Form 10-K filings almost completed, you may have noticed the addition of Accounting Standards Update No. 2016-02 “Leases (Subtopic 842)” to the MD&A subsection addressing new accounting standards. In short, companies will be required in the future to recognize most of their operating and finance leases as assets and corresponding liabilities on their balance sheets. For companies with significant leases, the financial statement implications may be considerable. Legal departments of such companies must understand these consequences and begin to plan accordingly.
The new standard represents the culmination of years of dialogue around the general issue of off-balance sheet liabilities. Regarding the subcategory of leases, a concern has been that current accounting rules, which essentially relegate lease-related obligations to financial statement footnotes, fail to adequately reflect a company’s aggregate financial obligations. New ASU 2016-02 moves most lease obligations onto the balance sheet and, according to FASB, thereby paints a clearer picture of financial condition. Lease assets will be measured at lease liability amounts, adjusted for lease prepayments, lease incentives received and lessee’s initial direct costs, while lease liabilities will equal the present value of lease payments.
Though the new standard, adopted on February 25, 2016, does not take effect until fiscal years beginning after December 15, 2018 (early adoption is permitted), there are steps to be taken and issues to be considered now in anticipation of the change:
- Processes must be implemented to identify all leases, both initially and continuously. While this may seem straightforward, note that leases come in all shapes and sizes, may be imbedded in other agreements and may be geographically far flung. Because legal departments typically manage all of the company’s contractual obligations, lawyers should be involved in the identifying and compiling process.
- Certain GAAP financial ratios, for example, leverage and return on assets, may be impacted by the new standard. While affected companies will, no doubt, provide disclosure explaining the change and may provide non-GAAP financial measure adjustments in some cases, it may also be appropriate to communicate directly with investors and analysts to explain the specific impact on your company. As with all such communications, care must be taken to comply with Regulation FD and coordinate the substance of these communications with the language in your SEC filings. Note also that the MD&A requires advance disclosure of known future events that may materially impact a company’s financial condition.
- Review the negative covenants in your loan documents to be sure the change will not trip any default provisions or limit the ability to borrow going forward. If so, now is the time to approach lenders or other counter-parties about amending these provisions to accommodate what is essentially an accounting change rather than a change in financial wellness.
- Likewise, as you negotiate new credit agreements, indentures or other agreements containing financial covenants, be sure to anticipate this pending change.
All the best,