Over the past few years, professional services firms worked diligently to understand and implement the new revenue recognition standards which had minimal impact on recognition, but did enhance the notes to their U.S. Generally Accepted Accounting Principles (“GAAP”) basis financial statements. Now firms should be turn-ing their attention and focus to the impact of the new lease accounting standards, whose implementation is on the horizon and will most certainly have financial statement implications. This piece is intended to provide a high-level overview on the financial statement implications of the new lease accounting standards (ASC 842) without getting into the actual ac-counting for the debits and credits.
Professional services firms who is-sue audited, reviewed or compiled fi-nancial statements under GAAP who have existing operating leases in place that exceed twelve-months in dura-tion (i.e., true month-to-month leases will not be impacted).
Under current GAAP leases are gen-erally classified as one of two types of leases: operating or capital. The classi-fication depends on four criteria where if any one criterion is applicable, the lease would be classified as a capital lease providing for the recognition of an asset and associated lease liability. If a lease did not meet any of the four criteria, it would be classified as an operating lease whose details (includ-ing the future commitments and mini-mum payments) would be disclosed in the notes to the financial statements as a commitment without balance sheet recognition. Generally, a firm’s lease for its office space is likely being classi-fied as an operating lease as the lease terms would not have triggered any of the four criteria triggering capital lease classification and recognition. The lack of recognition of operating leases on the balance sheet changes once ASC 842 has been adopted.
The new lease accounting standards are scheduled to take effect for private companies and private not-for-profits for fiscal years beginning after De-cember 15, 2021 and interim periods within fiscal years beginning after December 15, 2022. For firms with a calendar year end this impacts the De-cember 31, 2022 reporting year. (Note: the original effective had been a year earlier but was deferred because of the pandemic.)
Like many other changes in ac-counting, the genesis for change in-volves closing loopholes and provid-ing for greater transparency to users of the financial statements while also providing for less divergence in prac-tice. In the case of leases, the push for change began after the Enron scandal in 2001 and Enron’s use of “off-balance sheet operating leases” after which the Financial Accounting Standards Board began working on new lease accounting standards in 2006 so this change has been in the works for a while.
The how relates to how leases will be treated after adoption of ASC 842. First,there will be changes to lease terminology. What is now defined as a capital lease will be referred as a direct finance lease under ASC 842. The op-erating lease terminology will remain the same, but there will be additional recognition and new terminology as-sociated with operating leases. The recognition will include accounting for the operating lease on the firm’s balance sheet under the terminology “right of use asset” (non-current as-set) and associated liabilities — “lease liabilities” (current and non-current amounts).
The financial statement impact of the adoption of ASC 842 has the po-tential to directly impact certain key financial ratios including:
Current ratio: an increase in current liabilities will lead to a decrease in this ratio
Debt to equity/capital: significant in-creases to non-current liabilities will lead to an increase in this ratio
Debt service coverage: inclusion of operating liabilities as debt without an offset of the lease expense included in the operating cash flow will lead to this ratio being skewed
EBITDA: Should have little impact as the right of use asset will affect amor-tization expense and interest portion of the liability will affect interest ex-pense
As firms often have debt with fi-nancial covenants which may include some of the above, it makes sense to discuss the implications with the lend-er in advance and determine whether amendments to borrowing agree-ments are needed.
Although, generally speaking, pro-fessional services firms typically don’t have a significant portfolio of leases (unlike a distributor or manufacturer might) they do typically have an oper-ating lease for their office space that will need to be accounted for under the new lease accounting standards once adopted. Firms should begin to understand the potential impact to their GAAP financial statements, how to adopt and when adoption may make the most sense for their unique set of circumstances. Also of note for firms who issue GAAP financial statements that excluded footnotes, unknown operating leases to financial statement users will become known through the lease recognition (although the specif-ic details of the operating lease(s) will not be known).
Should you have any questions on how the adoption of the new lease ac-counting standards will impact your firm specifically, or need assistance in its adoption, please reach out to me or your relationship professional at Citrin Cooperman.
Jeff Stuart has over 16 years of ac-counting experience. He is a director in Citrin Cooperman providing a mix of audit, accounting, and tax compli-ance services to closely held business-es. Jeff’s industry expertise includes construction, real estate, manufactur-ing, and architectural and engineer-ing firms as well as employee benefits. Jeff can be reached at firstname.lastname@example.org
Citrin Cooperman is a full-service accounting and advisory firm with 18 domestic and international locations. Visit us at citrincooperman.com.