Lease Standard – Impact to the Dealership Industry’s Key Metrics and Financial Covenants

In February 2016, the Financial Accounting Standards Board (FASB) issued an Accounting Standards Update (ASU 2016-02) for Accounting Standards Codification (ASC) 842, Leases, that defines new principles for the recognition, measurement, presentation and disclosure of leases for both lessees and lessors. Under this new standard, a company is required to recognize most leases on its balance sheet, whether it was previously treated as a capital lease or an operating lease.

The guidance was effective for public business entities for fiscal years beginning after Dec. 15, 2018, (e.g., calendar periods beginning on January 1, 2019), and interim periods therein. As a result of the FASB’s decision to extend effective dates of leases and other accounting standards, the effective date for private companies is for fiscal years beginning after Dec. 15, 2020 (calendar periods beginning on January 1, 2021), and interim periods therein, with early adoption permitted. There are two methods an entity may use to transition from legacy standards to ASC 842. The first method requires companies to apply the new guidance as of the beginning of the earliest comparative period presented in the period in which the standard is adopted, while the second method allows companies to apply the new guidance at the beginning of the adoption period through a cumulative-affect adjustment to retained earnings, if any.

General Requirements of ASC 842

A company is required to evaluate whether a contract is a lease or contains an embedded lease within the contract, which is defined as being, or containing, a lease if it conveys the right to control the use of the identified asset for a period of time in exchange for consideration. The concept of “control” over the use of the asset means the customer has both (i) the right to obtain substantially all of the economic benefits from the use of the asset, and (ii) the right to direct the use of the asset. One example for a dealership to consider is billboard advertising. Depending upon the language of the contract, the dealership’s use of the billboard might constitute a lease and require the dealership to record a right-of-use asset (ROU) and lease liability. There are some other significant areas for dealerships that may be affected by these requirements, including: