New Leasing Standards
You may have heard mention of New Leasing Standards, a recent change in the rules issued by the Financial Accounting Standards Board (FASB) (Guidance Standard 842) to guide how to properly account for leases on financial statements. The goal of this standard is to have all leases accounted for on the Balance Sheet, providing a more complete picture of a company’s financial obligations, including loans and leases. While these changes most likely won’t affect your bottom line, we wanted to provide some helpful information in case you will have to evaluate this matter.
Basic Accounting Principles
A set of financial statements includes a Balance Sheet and Profit & Loss Statement (P&L). A Balance Sheet lists all the assets, liabilities and equity of a business at a given point in time. A P&L lists the income and expense of a company for a period, usually a year.
What Was The Old Lease Standard?
Under the old standard, a lease was either capital or operating. There were four major tests to determine if a lease was operating or capital. An operating lease was shown only on the P&L as an expense. There was no asset or liability recorded. A capital lease, conceptually very similar to a loan, was shown as a liability on the Balance Sheet with an offsetting asset booked. The cost was shown on the P&L over time, as the asset value and liability were reduced.
Many businesses tended to structure equipment financing as operating leases and didn’t show them on the Balance Sheet. Operating leases were expensed directly into the P&L under lease expense. Some argued that operating leases skewed the financial snapshot of the company by not showing all financial obligations on the balance sheet, which is why the new standard was pushed.
What Is The New Lease Standard?
Capital leases are now known as finance leases. The tests for qualification are very similar to the old standard. As outlined in our blog on capital leases, a lease is considered a finance lease if one of these criteria is met:
- Ownership is transferred to the lessee by the end of lease.
- A purchase option exists and is expected to be exercised.
- The lease term is for a major part of the economic life of asset.
- The present value of lease payments equals or exceeds the fair value of asset.
- The underlying asset is so specialized in nature that only the lessee can use it.
If a lease does not meet any of the above criteria and has a term greater than a year, it will still be classified as an operating lease but also shown on the Balance Sheet under the new accounting standards. They are expensed to the P&L through varying expense items as the asset and liability are reduced. Both methods treat a lease as if an asset is purchased and its cost financed.
How Does This Affect My Leasing Activity and Taxes?
Not much. You still get all the benefits of a lease – low upfront cash requirements, advantageous tax treatment, a simpler and quicker process than bank loans, and flexibility of terms. The new standard changes the financial presentation of the Balance Sheet, but not the substance and value of this financing option, nor how you run your business. Businesses with bank financing and substantial operating leases may have to renegotiate lending covenants for the additional liabilities created on paper by the new standards, but without any impact on the leasing agreements themselves.
For taxes, in general, this does not change the tax amount owed. Companies with operating leases still get a tax deduction for amounts paid under the new lease standard. The company does not recognize a Right of Use asset for tax purposes. Instead, a book to tax timing adjustment is created.
When Is This New Accounting Standard Effective?
The new standard is essentially effective for public companies and a few other special entities for fiscal years starting in 2019 (now) and for private companies for annual periods beginning in 2020. The standard does require comparative presentation between years when issuing financial statements, so companies will want to plan and start re-classifying leases one year ahead of time. When adopted, the new leasing guidance may have the largest-ever impact of a new accounting standard (in terms of gross dollars) on the Balance Sheets of lessees. Keep in mind, the actual rules are voluminous and as leases and companies become more complex, the rules will too. Here, we are simply sharing the basics we believe may relate to you.
Disclaimer: This is not tax advice. This does not, in any way, create an accountant/client relationship. If you have any questions about the information contained in this post, please contact your CPA to discuss the particulars of various lease accounting.
Jessica Kort is VP of Finance and Treasury for Amur Equipment Finance, Inc. She has a Master’s in Business Administration from the University of Nebraska Kearney and is a member of the American Institute of Certified Public Accountants and the Nebraska Society of CPA’s. Prior to joining Amur, she worked in Public Accounting, held Controller, Tax Manager, and Internal Auditor for two large manufacturers, and was the CFO of a trucking and logistics company. She loves entrepreneurship and helping people own and grow successful businesses.