I recently returned from a week of the dreaded 40 hours of annual continuing education required to keep my certifications valid (at least the classes were in beautiful Coronado, California). Since the Accounting Godfathers have finally agreed to new leasing standards and drop-dead dates for implementation, I included a course to review them.
I walked out of the class seriously questioning the sanity of the institutions that developed the standards. But at the same time, I thought a layman’s overview of the new standards and what their implementation means for our industry, and our dealerships, might be of value. So here I go!
I guess one of the first questions to answer is WHY the changes? There are several reasons, including:
Globalization – The new lease standards are more in line with international standards. Most of the world uses the International Financial Reporting Standards (IFRS), which are a single set of accounting standards developed and maintained by the International Accounting Standards Board (IASB). The goal is to be able to compare financial statements, no matter the country of origin, and ascertain that company’s financial performance on a like-for-like basis. The US Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB), have committed to developing accounting standards that converge over time. The lunacy of the leasing standards change is that there are still differences between FASB and IFRS!
Economic reality – The economic reality of most leases is that they are long-term arrangements (over 12 months) that typically transfer most of the risks and rewards of ownership to the lessee during the lease term, even though the lessee does not own the leased property.
Financial Statement Recognition – Since leasing is a form of financing, the new standards will provide greater transparency of a company’s leverage. Operating leases are giving way to a capital lease type of treatment for financial statements. Thus, the appropriate assets and liabilities will be included (recognized) on the balance sheet. Currently, lease reporting is focused on disclosure rather than recognition. Now, when leases qualify as operating (and most are recorded that way), neither the leased asset nor the liability is recognized on the lessee’s balance sheet but is disclosed in the foot notes.
Leasing Classifications
For at least the past 25 years, there have been two classifications of leases: capital and operating. As stated before, in our industry almost all equipment leases are considered operating leases except when there is a bargain purchase option. Under the current standards, the recording of the operating lease on the financial statement is easy—the lease payment is simply recorded to a rental or lease expense category. It will not be that easy in the future.
The new standards are as follows:
- Virtually all leases for equipment must be recorded on the balance sheet as a “Right-of-use” asset (I have not been able to find any circumstance where a current FMV lease would NOT be recorded on the balance sheet). The new standard will apply to all major equipment (office equipment, phone systems, etc.) purchases for any contract over 12 months in length.
- The new standards will go into effect for public companies for years beginning on or after December 15, 2018 and private companies for years beginning on or after December 15, 2019.
- A retrospective requirement will force companies to spend time restating financial statements for leases in effect before 2018. The retrospective is to enable financial statement comparisons starting in 2018.
What does this mean for your company internally?
Expect your administrative and accounting staffs to require more hours devoted to the disclosure, reporting, and tracking of all leases in which the company is engaged. There are specific guidelines to calculate the amount to book as “Right-of-use” assets and the corresponding debt. Then there is the calculation to record the amortization of the asset and the interest expense (this varies based on the terms and schedule of payments). Just hope that there are no quirky terms involved or it gets even more complicated!
The value of stand-alone assets (if identifiable) in “cost per print,” “bundled” contracts or any service contract in which the asset value is more than just incidental will be required to be separated from the service components of the contract. They will be recorded as “Right-of-use” assets with the corresponding debt. If the identification of the assets is not possible, the company can elect to record the whole contract as if it is the “Right-of-use” asset.
Also, remember that all existing leases in mid-term on the effective dates will have to be booked as “Right-of-use” assets. A company’s CPA should be able to help with the criteria to use for the calculations.
Impact on Covenants
Your bank covenants could be affected. Some typical covenants include thresholds for debt-to-equity ratio, net worth requirements, and other covenants that include liabilities as part of the calculation. Under current standards, the operating lease payment is an expense item. The payments do not affect these covenants. Even though the payment for the lease will not increase under the new standards, the recording of the “Right-to-use” assets for existing and new leases will result in new debt to appear on the financial statements. Any covenant that includes liabilities as part of the calculation will be affected adversely.
Also, your access to capital may be reduced if the bank limits capital expenditures to a certain amount and a “Right-to-use” asset is recorded. Our discussion in class revolved around the need to review your banking documents sooner than later, approach the bank to make them aware of what changes are coming, and amend the covenants as required.
Level Playing Field
Should a company lease or buy? The new standards put purchasing versus leasing on a level playing field. In the past, decisions might have been motivated by the availability of capital, accounting/tax treatment, and so on. By the time the standards are enacted, leases will be included on the company’s balance sheet as assets and debt, just like purchased items.
What does all this mean to my dealership, given 90 percent of equipment revenue is generated through leases?
It might not mean anything. Several of the large leasing company executives I polled do not seem to be concerned with the implementation of the new standards. They believe that a high percentage of SMB clients (those not required to provide audited or reviewed financial statements) will continue to book leases as they always have. That may be so.
My thoughts. I believe the percentage of leases booked to total business will decrease due to the following reasons.
Given a level playing field on a lease versus buy decision and adequate funding from the bank, a percentage of companies might opt to purchase equipment rather than lease. The reasons why a company might do this are as follows:
- A purchase would not entail the additional workload required for disclosure, tracking, and reporting leases
- The recording of leases on the financial statements will be comparably more complicated
- The ease of the transaction and favorable tax depreciation expense (bonus depreciation)
- Operationally in many companies, it used to be easier for management to engage in a lease transaction rather than go through the cumbersome process of capital expenditure requests. In the future, I would expect the same cumbersome process to be required for leases, and it will demand the coordination of several departments. Everything being equal, a capital expenditure may be easier.
- “Cost per print” and “bundled” leases could become a thing of the past as the “one monthly invoice” attraction of the contract could be outweighed by the extra burden of the accounting and reporting of the lease. We may have to say goodbye to the higher margins associated with these types of contracts!
Internal Compliance
In summary, while the new leasing standards may change the number of equipment lease transactions and how we engage with clients, I have more concern about our companies complying internally with the new standards than them hurting our top line business. Hopefully, this article piqued your curiosity enough that you will engage with your accountants/CPAs to chart the proper course to prepare your business for the changes. You will also want plenty of time to prepare your sales teams for the ever evolving financial landscape.
