With major changes coming down the road in the accounting for leases and revenue, now is the time to start planning for their impact on your business.
While these new standards were issued some time ago, it’s easy to overlook them as their implementation dates have been five or more years away. But each of these new standards brings with it the potential for significant change to financial statements. In turn, these changes impact important measurements for compliance requirements, employee and executive compensation arrangements, and debt covenants with financial institutions.
Revenue
The revenue recognition standard takes a significant number of existing standards, compiles them into one framework, and then adds new components to consider as well. The most important thing to remember about the new standard is that all revenue-producing customer arrangements and contracts should be evaluated against the new standard to determine their accounting treatment. In some cases, there might not be a change, but in many others change will be required. It’s best to know on which side of this change equation your company’s revenues lie.
For example, the new standard has these five key elements to guide this evaluation:
- Identify the contract
- Identify the separate performance obligations in the contract
- Determine the transaction price
- Allocate the transaction price to the separate performance obligations in the contract
- Recognize revenue when the entity satisfies its performance obligations.
In some industries, this five-step process — or some version of it — exists today. An example would include the software development industry where there are often multiple deliverables over a period of time with different pricing structures. And while your company may not be as complex as the software industry, the important thing to remember is that all revenue types and classes should be run through this funnel of the five key elements to determine the correct answer for revenue recognition.
This standard will be effective for calendar year-end companies in 2019. Given the complexity and its impact on one of the most key financial measures in any business — revenue — it’s time to start doing this evaluation now.
Leases
After much talk and debate over many years, leases will generally be on the balance sheet. There are a number of rules and principles to guide how they should be recorded and at what amounts, but the important thing to remember is that the balance sheet will be changing and liabilities will be increasing. In some cases, this change will be radical.
With leases on the balance sheet, it’s important to remember that leverage ratios (particularly with respect to debt covenants) will be changing. For example, a company that today has $50 million in liabilities, $50 million in equity and $20 million in future operating lease obligations would have a leverage ratio of 1:1. But using this simplified example, when the leases are recorded as a liability on the balance sheet, the leverage ratio would go to 1.4:1. This is a substantial change in the leverage ratio.
Earnings before interest, taxes, depreciation and amortization (EBITDA), a common measure of free cash flow, will be changing as well. This is because the “right to use” asset that is established for the lease will be amortized, generally over the lease term. The lease payments that were formerly an operating expense will no longer be an operating expense but rather will reduce the lease obligation (liability) while amortization expense will be recorded to reduce the right to use asset.
This standard will be effective for calendar year-end companies in 2020. Again, what seems far off is really something companies should be addressing today. As debt agreements are amended and re-financed over the next two to three years, it would be prudent to consider a company’s leasing activities when setting the forward-looking covenants, particularly those debt/equity covenants. This will save time in later years when the lease standard is formally adopted and causes financial ratios to change.
Originally printed in The Tennessean.