How could the phased-in GAAP accounting changes impact your decisions on operating and finance leases?

As more companies consider conserving cash by investigating leasing and other financing options, understanding the intricacies of lease accounting standards becomes crucial, especially with recent changes in the generally accepted accounting principles known as GAAP.

The shift from the old ASC-840 standard to the new ASC-842 allows GAAP accounting to better mirror international accounting standards, changing the accounting for some lease configurations that hadn’t appeared on balance sheets in the past. These new standards, which first applied to publicly held companies, will soon impact the financing decisions of privately held entities, as well.

Impact of GAAP accounting changes

In general, the new standards improve transparency of off-balance sheet leases, increase comparability between companies with different lease operating models, and ultimately reduce off-balance sheet financing.

“For years, they'd been reporting leases under a different set of rules,” says Pete Georgelas, Director of Business Development Capital Equipment Group at U.S. Bank Equipment Finance. "Suddenly, all leases were going to be reported on balance sheet. As a result, clients has to ascertain how they were going to manage reporting, not only future lease transactions, but leases they already have on their books."

The new accounting rules are being phased in for different kinds of entities. They went into effect for publicly held entities for fiscal years beginning after December 15, 2019 (2020 calendar year), but privately held entities received more time to adjust. For them, the new rules begin for fiscal years after December 15, 2021 (2022 calendar year) and interim periods after December 15, 2022 (2023 calendar year).

“It gives clients a whole new set of factors to consider,” Georgelas says. “For example, under the new accounting rules, a sale-leaseback with a contractual fixed buyout option will poison the well for operating lease treatment. Prior to implementation of the new accounting rules, you could do a sale-leaseback with a contractual fixed buyout option and still structure it to be qualified as an operating lease. Under the new accounting rules, this structure will be reported as a Loan Liability.” 

Understanding the changes

There are many ways to lease equipment, but in general, the structure is defined as either a finance lease or an operating lease.

• Operating lease: A contract allows for the use of an asset in exchange for rental payments but does not convey ownership rights of that asset. Organizations may use leasing for their short-term & long-term equipment requirements and at inception of the of the lease, the 75% economic useful life of the asset remains a valid threshold. 
• Finance lease: A finance lease is determined if the lease meets any one of the five defined lease criteria presented in ASC 842. Like the operating lease, in a finance lease, the lessor must grant the right to control the use of the asset to the lessee. The lessor must have control of the underlying asset to convey this right. Depending on the agreement, from a tax and legal perspective, a lessee may or may not be considered the asset owner. Typically, if the lease fully finances the cost of the equipment, the lessee is considered owner for tax depreciation purposes.
   

“The difference between a finance lease and operating lease is how it’s reflected in the financial statements. A finance lease is recorded like a loan – there’s an asset and a liability. In the financial statements, you disclose the interest and principal,” Georgelas says. An important and meaningful difference for the expense recognition besides interest expense vs. operating expense classification is the lessee operating lease expense is a single lease straight-line rent expense (easier for budgeting); finance leases have a front-loaded interest expense recognition that includes amortization and interest expense. “An operating lease is different, as it is reflected as a lease obligation on the balance sheet and not reflected as debt. In the financial statements, under ‘right-of-use, an operating lease may allow the lessee to capitalize their right of use asset at considerably less than the cost of the equipment.

Those terms and classifications are at the heart of the change in GAAP accounting standards. The Financial Accounting Standards Board (FASB) began the transition in 2018 from ASC-840, which much like its predecessor FAS-13, had four tests for operating leases and listed them as notes rather than balance sheet entries. Under ASC-842, all leases show up on the balance sheet, and the new rules also determine how those leases are listed.

In general, the new rules mean:

• All leases longer than 12 months are on balance sheet
• Present Value of the expected lessee’s lease payments are recognized as either debt for finance leases or other liabilities for operating leases.
• Service contracts are off balance sheet
   

“With a finance lease, the liability is classified as a debt obligation and impacts the leverage ratio” Georgelas explains. “The lease repayment is reflected in the financial statements as principal and interest, tantamount to a term loan.”

An operating lease, on the other hand, is not reflected as a financial asset & liability, but under a section titled “lease obligation”, so it doesn’t impact the leverage ratio. “Also, under the right-of-use portion of the operating lease, any deferred cost that the lessor takes in the form of an end-of-term residual that's not a payment obligation is not reflected in the financial statements, only the rent,” Georgelas notes. “There's a real benefit, especially on assets that have long economic life and value, in how that impacts not only the balance sheet, but the P&L and what the client is required to report.”

Although publicly-held entities already navigated the move to these new accounting standards, privately-help entities will face the same issues in the future, reevaluating the costs and benefits of various lease types as they turn over existing equipment leases as well as understanding the implications for financing new equipment going forward.

Weighing the options

When determining the proper structure for equipment financing, Georgelas suggests weighing a client’s liquidity preference and tax optimization strategy along with balance sheet and financial metrics.

“What is the best structure from both a Tax and GAAP Accounting standpoint? What are the drivers the client is most interested in? What are they really focused on? Enhancing return on equity, or return on investment, managing leverage ratios and financial covenants? If one of your primary covenants is funded debt to EBITDA, you don't want an operating lease, because it acts counter to that specific formula. If your primary driver is fixed charge coverage, liquidity or managing leverage, then the operating lease can provide tremendous value.”

Contact a U.S. Bank Equipment Finance specialist for more information.