For decades now, businesses have been able to treat certain capital transactions as “off-the-books”, meaning that they didn’t have to record the debt and capitalize the asset. This method of treating leases was codified in ASC 840. This is all about to change for leases beginning in the year 2020 for small businesses. Beginning in 2020, (2019 for publicly traded companies) lease transactions will follow ASC 842.
The new lease rules will hit lessee’s hardest. Lessor’s will see some new disclosure requirements but their accounting treatment will remain similar to what they do now.
The biggest change? Beginning in 2020, you will be required to show a debt for the lease commitment and related asset for the “Right of Use” of the leased asset. This means all that equipment you have been leasing will now show up on the balance sheet and run up the amount of debt you have on the books.
This may well have a major impact on businesses with loan covenants which restrict the amount of debt that the Company can incur. If you are a business, such as a highway contractor, who leases equipment, you will want to start talking with your lender and bonding agent about the potential impact of this new accounting standard.
As for the technical details of the new standard, one thing that changes is in the definitions. Property and buildings are now the only things considered operating leases. Almost every other asset lease will be considered a financing lease. The split is based on the “Consumption (usage and wear) of the underlying lease asset”. If the lessee “consumes” a significant portion of the asset, it is considered a financing lease. If it doesn’t, it is a capital lease.
An example might help.
You need warehouse space. You find 5,000 square feet of warehouse space and lease it for $12.00/sf for a 5 year term. At the end of the lease you will turn it back to the lessor in the same condition you originally found it.
Since the land will last indefinitely and the structure 50 or more years, you are considered to not put significant wear and use (i.e. consume) on the leased asset. Accordingly, you enter into a capital lease.
In comparison, you are going to lease 3 trucks for your business to deliver goods to customers. These are 60 month leases for $1,000 each truck. You could purchase the trucks new for $70,000 each. Since the trucks have a typical economic life of 7 years and the lease payment represents a substantial portion of the asset’s value, these would be considered financing leases.
Why does it matter? Well, as you might infer from the name, financing leases will report financing costs – interest expense. Capital leases will only report lease expense. However, both do require recording the lease asset – the Right of Use (RoU) and the corresponding liability at the present value of the lease payments.
To calculate the present value, you need to know 3 things: 1)The number of periods to make the payment; 2) the payment amount; and 3) the interest or discount rate. Guess what, 2 of the 3 are provided but the interest rate? Typically not.
The interest rate to use will either need to be stated by the lessor or you as the lessee will need to impute your rate. So, for the truck lease above, the capitalized value with an interest rate of 4.5% is $53,000; but if the interest rate is 9.0%, then the amount capitalized is only $47,000. And if your only source of additional capital is your credit card at 18% interest, well, your capitalized value will be much lower but your interest cost will skyrocket.
Why does all this matter? Because there is far too much debt off balance sheet and note disclosure, especially for small business, was typically weak on the subject of the lease contingency. Although there is some additional work, it doesn’t take a huge amount of skill to set up a PV formula in Excel. Obviously, the hard part will be in identifying the interest rate to use and also to account for step increases and other lease costs but it is not terribly complex.
As you approach 2020, make sure your accountant is up-to-speed on the new lease rules. You as the business owner or bookkeeper will need to provide more information to the accountant so it is set up correctly and the asset and debt recorded. And you will want to make sure you have a conversation with your lender well in advance of that financial statement as you do not want underwriting surprised by the sudden increase of debt that shows up on your financial statements.
Have a great day. If you would like to know more about the details of the upcoming changes to the lease rules, you should discuss with your accountant or feel free to write me anytime. And if you are looking for a more proactive accountant, feel free to contact me anytime for a free consultation.