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Operating vs. Finance Lease – How This Distinction Impacts Businesses Under the New Lease Standard

Tick tock, tick tock, tick tock. The clock is ticking on the countdown to the implementation of Accounting Standards Update (ASU) 2016-02 Leases, which overhauled the accounting rules relating to lease accounting. According to SEC reports focusing on public companies and a US Chamber of Commerce report, US companies currently have an estimated $2.8 trillion in operating lease obligations that are currently “off-balance sheet.”

Under the new accounting standard, it will be required for all, or substantially all, leases to be recorded on a company’s balance sheet. In reality, the standard is much more complicated. Although the impact of the standard will not be seen until the 2022 year-end financial statements for calendar year private companies, now is the time to start making decisions on what to do with items such as existing leases, proposed leases, and debt covenants.

Like the previous leasing standard, ASC 842 – Leases distinguishes between two primary forms of leases: 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.

First, let’s take a high level look at what factors determine your lease classification. 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 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 is 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 determination.

Now that you know whether your lease is an operating versus finance lease, the next question arises of what does it matter if both go on 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. Although these leases are now recorded on the balance sheet under the new standard, 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, the resulting expenses are found in two different areas of the income statement. First, the right of use asset is an amortized straight-line and is recorded as an amortization expense over the shorter of the related asset’s economic life or lease term. The second component of expense 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. 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 finance lease will incur approximately a 15-20% higher annual lease expense in the earlier years, as compared with an operating lease. That higher amount reverses in the later years of the lease.

The distinction between income statement classification 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.

Additionally, the inclusion of both operating and finance leases on the balance sheet may negatively impact a company’s accounting ratios. This may result in adverse impacts to a company’s financial covenants. Interest coverage ratios may also be impacted due to the additional interest expense from adoption of the new standard if leases previously recorded as operating now require recognition as a finance lease.

Due to the expected significant impacts on these ratios and other financial statement implications, it is important for companies to be working with their lenders to renegotiate existing covenants to account for this change in accounting. Don’t wait until the standard is fully implemented, the time to act is now.

We have discussed the impact of the standard on existing leases, so the question then becomes what do we do going forward? Which classification of lease should a company pursue (operating or finance)? Or should it forego leasing assets altogether and simply purchase/finance them? The answer is, IT DEPENDS.

By implementing this accounting standard, the GAAP differences between leasing versus owning an asset have been reduced. Having to now capitalize all leases will likely heavily impact this decision, especially when it comes to real estate.

It is important to consider that a similar amount of debt will be on the balance sheet, regardless of whether it is leased or financed. GAAP depreciation expense each year may be less than amortization under a lease because the life under the lease will likely be a shorter duration. Lease terms may also now be structured so they are shorter in duration to avoid placing larger lease obligations (and the related asset) on the balance sheet.

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 into in the future.

If you need further guidance or have any questions on this topic, we’re here to help. Please do not hesitate to reach out to our trusted experts to discuss your specific situation.

This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.