The Financial Accounting Standards Board has issued new rules related to accounting for leases. The rules take effect for public companies beginning 12/15/18 but will require some consistency in reporting so firms are changing to account for their leases in the new manner in 2017. For non-public companies, the rules take effect 12/15/19.
The rules require that all but the shortest leases be accounted for as if the lessee purchased the asset and borrowed the purchase price. A new asset is setup – a Right to Use asset. This asset is depreciated in the same manner that it would have been had the lessee bought the item outright. The liability for the payments is the sum of present value of the lease payments over the life of the lease + any upfront payments + direct costs incurred by the lessee less any lease incentives from the lessor. The asset is set up for the same amount as the liability. Over the life of the lease, payments reduce the lease liability and have an interest expense component.
Where the rules get tricky is how the interest and depreciation is accounted for. If the lease meets the criteria as an operating lease, then the interest and depreciation are treated as lease cost and an operating expense. The lease payments and interest are amortized straight-line over the life of the lease and the asset’s depreciation is charged to lease cost not depreciation expense. The lease is a financing lease, which means it meets any of the following criteria:
- The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
- The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.
- The lease term is for a major part of the remaining economic life of the underlying asset. This criterion is not applicable for leases that commence at or near the end of the underlying asset’s economic life.
- The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already included in the lease payments equals or exceeds substantially all of the fair value of the underlying asset.
- The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.
Financing leases are accounted for as a purchase with associated borrowing but the interest will show on the financial statements as interest and the depreciation as depreciation.
The tax rules treat most lease payments as operating expenses and do not recognize the asset, liability, interest or associated depreciation. The adjustments between your books and tax return will grow more significant.
In short, if this is new information to you, sit down with your B2B CFO® and CPA and figure out the implications. You may find it best to change how you structure asset purchase financing. These changes may also impact your banking relationships. Your B2B CFO® can help you work with the bank to make sure the new lease rules do not cause you to trip over loan covenants.
Start now as the information that will need to be collected and the processes that need to be revised may be significant for your firm.