New Lease Accounting Standard by FASB
On February 25, 2016, FASB issued a new accounting standard ASC 842 – Leases, which companies are required to adopt in a phased manner.
As per the new accounting standard, companies are required to report a right-of-use asset and lease liabilities as separate line items on the balance sheet.
For public companies, the new accounting standard is applicable beginning January 1, 2019. For all other entities, it is applicable beginning on January 1, 2020. Companies may voluntarily opt for early adoption.
With the adoption of this new lease accounting standard, public companies will start recording operating leases on their balance sheets instead of just recording the expenses in the footnotes of financial statements. All obligations related to the lease will be recorded as a liability on the balance sheet, offset by a “right of use asset”.
Below is the screenshot of the balance sheet of Delta Airlines Inc., which has adopted this new accounting standard.
We can see that the current liabilities and non-current liabilities have increased by $955 million and $5,801 million, respectively, as compared to the previous year due to the inclusion of operating leases liabilities. The non-current assets of the companies have increased by $5,994 million due to reporting of right-of-use assets related to operating leases.
Impact of this standard on Companies and their Financial Ratios
With the adoption of this new accounting standard, companies are expected to book around $3 trillion of lease liability on their balance sheets, based on estimates of the International Accounting Standards Board.
Key financial ratios, such as the debt-equity ratio and other leverage ratios, are likely to get adversely affected by the adoption of this standard, and in turn, affect the borrowing capacity and debt covenants of companies.
To illustrate this, below is an example of a balance sheet of a company, before and after the adoption of the standard.
We have presented a few ratios to show the impact of recording operating leases on the balance sheet.
| Ratios | Ratio, before the adoption of ASC | Ratio, after the adoption of ASC | Change | Impact |
| Debt-equity ratio (Total Debt / Total Equity) | 23% | 33% | 46% | This ratio measures the degree of indebtedness of an enterprise and gives an idea to the long-term lender regarding the extent of security of the debt. A low debt-equity ratio reflects more security. A high ratio, on the other hand, is considered risky as it may put the firm into difficulty in meeting its obligations to outsiders. An increase in operating liability of $6,000 has increased this ratio by 46%. |
| Current Ratio (Current Assets / Current Liabilities) | 3.89 | 3.61 | -7% | This ratio provides a measure of the degree to which current assets cover current liabilities. The excess of current assets over current liabilities provides a measure of the safety margin available against uncertainty in the realization of current assets and flow of funds. An increase in current liability of $1,000 has decreased this ratio by 7%. |
| Quick ratio ([Current Assets – Inventory – Prepaid expenses] / Current Liabilities) | 2.37 | 2.20 | -7% | The ratio provides a measure of the capacity of the business to meet its short-term obligations without any flaw. An increase in current liability of $1,000 has decreased this ratio by 7%. |
As we can see, the debt-equity ratio, which is one of the key ratios used while determining borrowing capacity and defining debt covenants, is significantly impacted on account of an increase in operating liability.
Which sectors will be most impacted?
Sectors where assets are largely operated on leases, such as the retail sector, airlines, and telecommunications will be impacted more than others.
Accounting Treatment
Accounting Treatment by Lessee
Accounting of short-term leases, finance leases, or operating leases by the lessee is specified in ASC 842-20.
- Operating leases: Requires lessee to capitalize operating leases on the balance sheet as a right-of-use asset and a lease liability.
- Exceptions to the above rule are short-term leases less than or equal to 12 months in duration, which do not have to be capitalized on the balance sheet.
Accounting Treatment by Lessor
Accounting of sales-type leases, direct financing leases, or operating leases by lessors is specified in ASC 842-30.
The accounting treatment by the lessor largely remains the same. Lessor will continue to recognize lease income on a straight-line basis over the lease term.
In the 2018 US GAAP Taxonomy, new elements related to operating leases were introduced by FASB, to meet the new disclosure requirements of companies. A few of the elements are:
| Element Name | Documentation |
| OperatingLeaseRightOfUseAsset | Amount of lessee’s right to use underlying asset under an operating lease. |
| OperatingLeaseLiabilityCurrent | Present value of lessee’s discounted obligation for lease payments from operating lease, classified as current. |
| OperatingLeaseLiabilityNonCurrent | Present value of lessee’s discounted obligation for lease payments from operating lease, classified as noncurrent. |
| OperatingLeaseLiability | Present value of lessee’s discounted obligation for lease payments from the operating lease. |
