Operating vs. finance leases: The impact of the new standard

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The clock is ticking on the countdown to the implementation of the new lease accounting standard for private companies.

According to reports from the Securities and Exchange Commission and the U.S. Chamber of Commerce, U.S. companies currently have an estimated $2.8 trillion in operating lease obligations that are presently off-balance sheet. Under the new accounting standard, nearly all leases will be required to be recorded on a company’s balance sheet. However, the reality is the new standard is much more complicated than that.

Although a recent proposal from the Financial Accounting Standards Board would push back implementation until year-end 2020 for most private companies, now is the time to start evaluating and making decisions on what to do with existing leases, proposed leases and debt covenants. (The standard was previously scheduled to take effect at the end of 2019 for private companies. It has already taken effect for public companies.)

Similar to the previous leasing standard, leases under the new standard are distinguished by two primary forms: an operating lease and a finance lease (replacing capital leases under the old standard). This distinction is important, especially because it determines where and how much rent expense is recorded in the accompanying income statement.

Classifying leases

Comparable to the old standard, there are five criteria to consider when determining your lease classification. If a company’s lease meets any of the criteria below, it will be required to record its lease as a finance lease under the new standard:

1. Transfer of ownership: The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
2. Bargain purchase option: The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.
3. Lease term: The lease term is for a major part of the remaining economic life of the underlying asset, which includes renewal periods reasonably expected to be exercised.
4. Present value: The present value of the sum of the lease payments, and any residual value guaranteed by the lessee that is not otherwise included in the lease payments, represents substantially all of the fair value of the underlying asset.
5. Specialized nature: 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.

While the above criteria are similar in nature to the previous capital lease criteria, it’s important to note the absence of the “bright line” tests that used to be associated with the lease term and present value criteria. The decision now involves a certain amount of judgment in making the correct determination.

Balance sheets

Once a lease is classified, the next question is: What does it matter, if both go onto the balance sheet anyway? The answer lies in how the resulting expenses are classified in a company’s income statement.

For operating leases, under the new standard, even though these leases are recorded on the balance sheet, expense recognition remains the same as under the old accounting rules. The expense is recognized as a rent expense and is recorded in the financial statements under cost of sales/operating expenses.

If a company determines it has a finance lease, though, the resulting expenses are found in two different areas of the income statement. First, the right of use asset is amortized straight-line and is recorded as an amortization expense over the shorter of the related asset’s economic life, or the term of the lease. The second component relates to the interest expense on the associated lease liability.

Impact of income statement classification

The distinction between income statement classifications can have a significant impact on a company’s profitability ratios, as well as earnings before interest, taxes, depreciation and amortization due to the difference in expense classification depending on the nature of the lease. Changes in EBITDA and other profitability ratios may affect existing agreements related to compensation, earnouts, bonuses and commissions.

In addition, the inclusion of both operating and finance leases on balance sheets may negatively impact a company’s debt/equity ratios. These may result in adverse impacts to a company’s debt covenants. Due to the additional interest expense from adoption of the new standard, interest coverage ratios will also be impacted. As a result, it’s important for companies to work with their lenders to renegotiate existing covenants to account for this change in accounting.

What should my company be doing?

Based on all of the above, which way should a company classify its leases? Should it forego leasing assets altogether and simply purchase or finance them? The answer is it depends.

By implementing the new accounting standard, the GAAP differences between leasing versus owning an asset have been reduced. Therefore, having to capitalize all leases will likely heavily impact the decision to lease or purchase, especially when it comes to real estate. Key considerations include:

  • A similar amount of debt will be on the balance sheet, regardless of whether it was leased or financed.
  • Each year, GAAP depreciation expense may be less than amortization under a lease because the life under the lease will likely be for a shorter duration.
  • Lease terms may now be structured so that they are shorter in duration to avoid placing larger lease obligations (and the related asset) on the balance sheet.
  • As the tax laws have not changed, most leases capitalized under the current standard will result in the creation of a deferred tax asset. As such, the decision to lease will result in factoring in these deferred tax assets and the related accounting. Additionally, GAAP expense will generally be greater than lease expense for tax purposes as a result.

In the end, a company must carefully consider its situation and how this standard will impact both its existing and future leases. With less than a year before the standard goes into effect for private companies, now is the time to act and prepare, rather than waiting until the standard is fully implemented.

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