The Financial Accounting Standards Board issued new guidance for leases in 2016. If you have a fair number of operating leases including land cash rents, the changes might be material.
Why did the standard change? The lease-accounting rule changed to provide more useful information to users of financial reports. It is also a response to a Securities and Exchange Commission directive to bring assets and liabilities onto the balance sheet.
When will the rules take effect? For most farmers, the standard will go into effect for financial periods starting after Dec. 15, 2019—in other words, they will apply to 2020 calendar year-ends. But if you do comparative financial statements, it will go into effect for the earliest period shown on the financial report.
Are the rules retroactive? The new rules will be implemented retroactively, so all operating leases will need to be capitalized in financial reports in the transition year. For comparative financial statements, operating leases must be capitalized for the earliest period presented.
What will change? The operating lease will appear on the balance sheet as an asset and a liability. Yet the rules will have little or no change to your income statement or to the classification of lease contracts. Balance-sheet ratios might change.
Will I have to recognize all leases on my balance sheet? The short answer is yes. Yet there are some exceptions, such as contract duration of less than 12 months or a contract for services.
Review these shifts with your banker before they take effect.
Lease Rules in Action
The complexities of new farm-lease standards are easier to understand with an illustration. Suppose Farmer Jones enters into a new operating lease for a tractor. The lease calls for four payments of $75,000 and allows the farmer to purchase the tractor for fair-market value at lease termination. The present value of the operating-lease payments is assumed to be $275,000.
Under these lease terms, here are some of the consequences for key financial metrics:
Return on Equity (ROE): No change. ROE is calculated as net income divided by equity. The ratio is unchanged because both net income and equity remain the same after the new standard.
Return on Assets (ROA): Decline. ROA is calculated as net income divided by assets. Although there is no change to net income, assets will increase, so this ratio will decline.
Debt-to-Equity: Might or might not decline. If banks treat the operating lease liability as part of debt, this ratio will decline. Equity will remain the same, but debt will increase.
Total Liabilities: Increase. The lease liability will be on the balance sheet, which will result in an increase in liabilities.
Earnings before interest, tax, depreciation and amortization (EBITDA): No change. EBITDA margin is calculated as EBITDA divided by revenue. There is no change to EBITDA under the new rules because the operating lease is recorded as a lease expense under the current
and future guidance.