New lease accounting rules will require all leases to be on corporate balance sheets, even though the Financial Accounting Standards Board (FASB) has yet to circulate the final FASB Exposure Draft, which details the changes.
“Until the dust settles, it’s very difficult to make any kind of strategic decision,” says R. Timothy Evans, president of Equipment Finance at FirstMerit Bank. “Yes, it will have a negative impact on some segments of the leasing business for both lessees and lessors, but it’s not going to signal the end of the equipment leasing industry by any stretch.”
Smart Business spoke with Evans about who will be impacted and how operating leases will function when the new rules take effect.
Where does everything stand right now?
Companies currently report operating leases in the footnotes, while incorporating capital leases on the corporate balance sheet. To create more transparency, the FASB wants all leases on the balance sheet.
In the current draft, only operating leases of less than 12 months are allowed off-balance sheet. However, many organizations are lobbying to have more exceptions included, creating further delays.
The current expectation is an implementation date of late 2016 or early 2017, but that could get pushed back.
What distinguishes an operating lease?
An operating lease has to meet four main criteria, as defined by FASB:
- Rentals and all guaranteed rents discounted back at the customer’s borrowing rate cannot exceed 90 percent of the equipment cost.
- Term cannot exceed 75 percent of the economic life of the lease property.
- Cannot transfer ownership of the property at the end of the lease term.
- Cannot contain an option to purchase the property at a bargain price.
If your lease violates any of the criteria, you must characterize it as a capital lease.
Why do companies favor operating leases?
An operating lease offers an extremely low ‘cost of use’ for a company that is capital intensive. As an example, if a company has net operating losses, it cannot utilize depreciation. With a true lease structured as an ‘operating lease,’ the lessor takes the depreciation and prices a residual into the deal, giving the lessee a lower rate.
Operating leases require no down payment and give the flexibility to return the equipment at the end of the term. Companies can upgrade to state-of-the-art equipment without large down payments.
A point to clarify is that for accounting purposes, a lease is either operating or capital. For tax purposes, it’s either true or capital. There are components of an operating lease that are also components of a true lease — the two aren’t synonymous. Operating leases are off-balance sheet, but not all true leases are operating leases.
How are companies preparing?
Right now, there’s not enough clarity to develop a strategy. A company with many leases must search through every contract, identify the operating leases and then reconstruct the rent stream in order to report it on-balance sheet. Many may decide to outsource this to accounting firms.
What’s the anticipated impact?
Companies that just lease to have off-balance sheet treatment will see a major impact. But this change does nothing to modify a lessor’s ability to take depreciation, price residuals and offer creative structuring for the standard equipment financing.
Eight out of 10 companies have some kind of equipment lease, but that doesn’t mean all are operating leases. For most lessors, the operating lease piece of their business generally is less than 20 percent. Some lessors specialize in operating leases.
Almost every bank monitors and restricts the amount of leverage on a balance sheet through covenants. With the accounting change, some businesses’ balance sheets will have too much debt, so covenants and lending agreements will need to be restructured. However, many lenders already look at the operating leases in the footnotes, so there could be other ‘work arounds’ to deal with the new requirements. It’s expected there will be at least 12 months to complete the transition to the new requirements.
R. Timothy Evans is president of Equipment Finance at FirstMerit Bank. Reach him at (330) 384-7429 or firstname.lastname@example.org.
All opinions expressed herein are those of the authors/sources and do not necessarily reflect the views of FirstMerit Corporation. FirstMerit is not offering tax or accounting advice. We recommend you consult with your tax or accounting adviser.
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