>> What You Need to Know

The wait and uncertainty is over.  The new lease accounting rules have been confirmed, and will be implemented in three years.  The new rules will increase transparency in accounting by bringing Operating Leases onto the balance sheet. 

Here is what you need to know.

2 Kinds of Leases

Historically, leases have been categorized as either “Capital” or “Operating.”  Capital leases, also called $1 Buyout Leases, are a solution generally selected by clients who want to own the equipment at the end.

Operating leases, also known as Fair Market Value (FMV) leases, are essentially an equipment rental solution for clients who need to upgrade frequently.  With this structure, clients have the option at the end to return the equipment, continue to lease it, or purchase it for its then fair market value. 

Going forward, there will still be two kinds of leases, but they will be known as “Finance” (instead of “Capital”).  Operating leases will maintain their name, although the lease accounting change will take place with the Operating lease structure. 

• Capital Leases will be known as Finance Leases.
• Operating Leases will still be called Operating Leases, but they will be shown on the balance sheet as “other” liability.

3-Year Transition

Seven out of ten organizations use financing to acquire equipment.  Therefore, this accounting change, although not complex, will affect thousands of businesses.  The guidelines will also be implemented retroactively, meaning that all existing off balance sheet leases will need to be recorded on the balance sheet.  For these reasons, there is a three-year period until the guidelines are implemented.

1 Additional Step

Once Operating Leases are capitalized, or placed on the balance sheet, one additional step will be required for organizations.  They must recognize the “value” of the asset as a right-of-use (ROU) asset on the balance sheet, and will also book a corresponding liability for the minimum lease payments, discounted at the rate implicit in the lease.

The discounted asset amounts (rental / ROU amount), therefore, will be lower than the cost of an outright purchase. 

$0 Additional Debt on Balance Sheets

The Operating Lease liability will not be reported as debt in the lessee’s financial statements.  It will be listed under “Other” liability.  Indeed, FASB specifically stated that a capitalized lease obligation that does not meet the UCC definition of debt is to be reported on the balance sheet as “non-debt.”

Debt Limit Covenants

Capitalized liability should not result in a technical default under debt limit covenants. 

Lower Costs

The capitalized asset cost for Operating Leases is lower than a loan or cash purchase because the balance sheet presentation of an Operating Lease reflects only the present value of the rents due under the contract as the asset amount.  As a result, it is still “partially” off of the balance sheet.

Furthermore, since the cost of an Operating Lease is reported as a straight line expense of the full lease payment each period, there is no front-end P&L impact that comes from expensing depreciation and imputed interest costs, as there is when you borrow to make an outright asset purchase.

Stronger ROA

The net result is that even with the new lease accounting guidelines in place, leasing will show a better return on assets (ROA) compared to borrowing to buy your equipment assets.

Flexibility

As always, the benefits of leasing include low payments, simple upgrades and add-ons during the lease, financing for hard and soft assets, and more.  Below is a quick overview of equipment leasing services before and after the lease accounting changes.

Snapshot of First American’s Offerings