Many closely held businesses lease machinery, equipment or real estate. Historically, most leases were accounted for “off balance sheet.” This is about to change under a new lease accounting standard issued in February 2016.
Shifting the Reporting Paradigm
Under current U.S. Generally Accepted Accounting Principles (GAAP), companies are required to record lease-related assets and obligations on their balance sheet only if the lease meets the definition of a capital lease. If none of the conditions for a capital lease are present, the lease is generally considered an operating lease and the lessee simply records the payments as expenses on the income statement, with no balance sheet recognition of lease-related assets or obligations.
The current accounting rules give companies significant leeway to structure deals to achieve operating lease accounting. Investors and lenders often complain that this practice makes lessees appear more financially secure than companies that take out loans to buy the same assets. This is because for some companies — such as contractors that rent all their office and warehouse space and equipment— lease payments represent significant financial obligations, but these obligations are not apparent on their balance sheets.
In February, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2016-02, Leases, which contains a dual approach for classifying leases based on criteria similar to current U.S. GAAP. The new standard requires a lease to be classified as a finance lease when (1) payments represent substantially all of the fair value of the asset, (2) the lease term is for a major portion of the asset’s economic life, (3) purchase of the asset is considered a bargain, (4) title transfer is automatic at the end of the lease, or (5) the underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term. The fair value and economic life tests are similar to the 90% and 75% tests under existing U.S. GAAP guidance, albeit without the bright lines. Under the new standard, a lessee will account for a finance lease by recognizing the “right-of-use” (ROU) asset separately from interest on the lease liability. It should be noted that these changes will only apply to companies which issue GAAP-based financial statements. The changes in lease accounting would not apply to companies whose financials are reported on an income tax basis.
The most significant change will be for operating leases, where costs will be presented as lease expense and recognized on a straight-line basis in the income statement over the lease term. Importantly, however, the lessee will recognize an asset and a lease liability for both finance leases and operating leases. The only exception to this presentation will be for short-term leases (i.e., a term of one year or less), which would not be recognized on a lessee’s balance sheet.
Postponing the Implementation Date
For public companies, the new standard will be effective for fiscal years beginning after December 15, 2018. Private companies will have an extra year to comply.
Despite this delay, proactive companies should begin talking to a financial advisor about how the new lease standard is likely to affect their financial statements and debt-to-equity ratios. Doing so can help preempt negative consequences related to this major change.
Lease or Buy?
When it’s time to acquire new vehicles, equipment or warehouse space, decision makers often wonder, “Should I lease it or buy it?” The revised accounting standard on leases makes leasing seem less advantageous, but there still may be sound financial reasons not to buy an asset outright.
A lease is essentially a financing arrangement in which another company owns the particular asset and leases it to you at an agreed monthly rate for a specified term. At the end of that term, you can often opt to buy the asset, or simply return it and then lease or buy new assets.
Depending on how the contract is written, a lease may eliminate the need for a large down payment, reduce maintenance costs and preserve capital for other purposes. Leases also offer more flexibility in case the company moves in a different strategic direction than expected — or the leased asset becomes technologically obsolete.
Taxes also should factor into the decision. The classification of leases for tax purposes generally aligns with current accounting practice. Operating leases are typically deductible as an operating expense, and there may be advantages especially for items such as luxury vehicles. Conversely, capital leases provide tax deductions for depreciation, insurance, interest and repair expenses on equipment. For advice on whether to lease or buy, contact your financial advisor.
Companies that have not done so already will want to think through the potential impact, particularly in light of the requirement to retrospectively apply the standard to previously issued financial statements. Elliott Davis Decosimo is ready to answer your questions and provide the resources and training that you need. For additional details on the Lease accounting standard, please contact your Elliott Davis Decosimo tax advisor or a member of our assurance team.