Leasing is an important activity for many organizations – whether a public or private company, or a not-for-profit organization. It is a means of gaining access to assets, obtaining financing, and reducing an organization’s exposure to the risks of full ownership of the underlying asset.
The ASU affects all companies and other organizations that lease assets such as real estate, airplanes, and manufacturing equipment. The new standards in the ASU will go into effect in December of 2018.
When a company leases equipment or real estate (e.g. trucks, machinery for manufacturing and/or distribution space) there are generally two methods of reporting that lease:
- Treat it as an operating lease or
- Treat it as a capital lease (sometimes referred to as a “finance” lease).
Up until recently operating leases were included only on the income statement as rent expenses and not incorporated into the balance sheet.
Most financial institutions and investors would consider these items in a “off balance sheet” analysis, but the ASU brings operating leases front and center in order to improve consistency of financial reporting across the board.
Basically, operating leases will now be included as items on the balance sheet along with capital items.
Below I’m going to quickly break down when you should consider capitalizing your lease and the advantages/disadvantages of using both methods.
I would strongly recommend speaking to a licensed accounting professional on the topic before adjusting your processes/reporting.
How will my operating leases be calculated going forward?
The illustrations below sum up how liabilities and assets will be calculated on the balance sheet for qualifying leases. The changes apply to operating leases with terms longer than 12 months.
Does my existing operating lease qualify for capitalization?
You can capitalize a lease if any one of the following criteria is a characteristic of the lease transaction:
- The lease transfers ownership of the property to the lessee by the end of the lease term.
- The lease contains a bargain purchase option.
- The lease term equals 75 percent or more of the estimated economic life of the leased property.
- The present value of the minimum lease payments at the inception of the lease (excluding executory costs) equals at least 90 percent of the fair value of the leased property.
What is the advantage/disadvantage of capitalizing a lease?
Capitalization serves to conserve cash up front in the transaction since it mimics ownership. Basically, you’ll be able to lower your tax obligation by depreciating the capitalized asset over the life of the asset or lease period before you take on full ownership.
Side Note: If the entirety of the lease were to be expensed immediately (like a purchase), it would distort the company’s net income figure, showing unfairly reduced income. By capitalizing the amount and spreading the expense over the lease period through the depreciation process, these effects are reduced and it falls in line with other capitalized items.
The company’s net worth will not be impacted since the lease is reported as an asset with equal liability (they offset each other).
However, the increase in liability will have a negative effect on the company’s debt-to-equity ratio, which is typically viewed unfavorably from the perspective of regulators and investors.
What does this mean going forward?
- Shorter term leases will become more desirable.
- A longer term means the company will have to take on more liability which may not be desirable.
- Shippers will lean more heavily on 3PLs to take on lease liability to ease effect on balance sheet.
- You will see more triple net lease structures.
- The new standards require a lessee to record only the present value of future lease payments such as fixed rent during the initial term of the lease. Subsequently, variable costs that come from real estate taxes, insurance, common area maintenance, utilities and janitorial expense can be excluded from the equation, which also makes it easier to calculate and manage.
I would strongly encourage you to have your CFO take a hard look at what the ASU means for your company and connect with professionals, like me, to build a proactive strategy and process for your firm that keeps you out of panic mode.