The clock is ticking on the countdown to implementation of Accounting Standards Update (ASU) 2016-02 Leases, which overhauled the accounting rules pertaining to lease accounting. According to reports from the SEC and the US Chamber of Commerce, US companies currently have an estimated $2.8 trillion in operating lease obligations that are presently “off-balance sheet.”
Under the new accounting standard, all (or nearly all) leases will now be required to be recorded on a company’s balance sheet. However, the reality is that the new standard is much more complicated than that. Although it’s not required to be implemented until year end of December 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.
Similar to the previous leasing standard (ASC 842), under the new standard, leases 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 your lease
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:
- Transfer of ownership: The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
- Bargain purchase option: The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.
- 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.
- 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.
- 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.
Once you classify if your lease is an operating versus a finance lease, the next question that arises 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.
First, let’s look at operating leases. Under the new standard, even though these leases are recorded on the balance sheet, expense recognition remains the same as 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 term of the lease. The second component relates to the interest expense on the associated lease liability.
Over the term of the lease, the total expense recognition will be the same under either lease classification. Even lease expense (interest and amortization expense) under a finance lease is higher in the earlier years, as compared with lease expense under an operating lease. On average, a ten-year lease will incur approximately 15-20 percent higher annual lease expense in the earlier years, if capitalized, as compared with a lease not being capitalized. That higher amount reverses in the later years of the lease.
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 (EBITDA) 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, earn outs, 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 be working with its 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/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 leave versus purchase, especially when it comes to real estate.
Things to consider 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.
- Deferred taxes: under current accounting standards, most leases are treated as operating ones, similar to the income tax rules. Since 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 leases, and those it intends on entering in the future. With less than a year before the standard goes into effect, the time is now to act and prepare, rather than waiting until the standard is fully implemented.