December 3, 2018
By Peter Bullen
For most manufacturers, December is a time to make one last push toward meeting sales quotas and to make plans for the coming year. As we move into 2019, however, U.S. businesses will have an extra variable to plan for: changes to lease accounting rules. After a decade of discussion, the new rules, released in 2016 by the U.S. Financial Accounting Standards Board, take effect for public companies this December, and for private companies in 2019.
The new lease accounting regulations require that a portion of operating leases appear on every business balance sheet. Initially, some observers thought the new accounting rules might threaten revenue or profitability. The final rules, however, impose less stringency than anticipated. While the accounting for operating leases has changed, the primary benefits of equipment leasing remain for industrial and manufacturing businesses.
Although this means only minor changes to most businesses, and mainly from an accounting perspective, it’s important for manufacturers to understand the changes and to make a plan for complying with them.
Changes in operating leases
First, it’s important to know that the overall impact to businesses will be nominal. Compared to the accounting treatment of a traditional loan or purchase transaction, leasing is still a prudent equipment acquisition strategy. Here’s why:
- An asset value is booked equal to the present value of rents as “right- of-use” (ROU), and an offsetting liability entered as “obligation to pay.”
- Because the liability is considered non-debt (other debt), it may not jeopardize debt-limit covenants.
- Operating leases are residual-based structures. Consequently, the asset and liability recorded may be less than the cost of the asset. This yields a lower on-book balance than does financing with a traditional loan.
The final guidelines are much less retributive than many options originally proposed, and the
answers to many of the questions still circulating today are both positive and straightforward. One of the most common, questions, for example, is what happens to a company’s credit rating if it capitalizes operating leases on the balance sheet. The fact is, most bank lenders and credit analysts already take footnoted operating lease obligations into account when assessing debt and liquidity ratios, so the changes in lease accounting regulations have very little impact here.
According to FASB and the Uniform Commercial Code (UCC), an operating lease is not a debt. Operating lease liabilities will now be listed in a non-debt category, such as “Other Liabilities,” which helps alleviate concerns about violating debt limitation covenants from other loan contracts if leases appear on the balance sheet.
Also, under the new guidelines, assets on an operating lease will be booked on the balance sheet, resulting in a straight-line P&L expense. Therefore, when compared to a loan, a lease yields better earnings benefits, especially in the initial years of its term.
While the new guidelines indeed incur some changes to accounting practices, it’s important to recognize that leasing continues to be a judicious business decision. Here’s a breakdown of the benefits:
Alternative capital source
- Preservation of cash and lines of credit
- Fixed rate (vs. revolver)
Cash flow savings
- 100% financing, level payments
- Financing for training and installation costs
- Skip / seasonal payments
- Lower payments resulting from tax benefits and residual investment by lessor
- Expensing of full payment on income tax returns
- Trade potentially unusable depreciation benefits resulting from 100% expensing for lower payments and rates
- Options to fit varying business needs at end of lease
- Simplified add-ons / Easier upgrades
- Manage technology cycle / reduce obsolescence risk due to ability to return equipment
- Manage asset replacement cycles
- Streamlined financing process for many transactions
- Often available at point of sale
Make a Plan
Although the impact of the lease accounting changes is minimal, businesses are still faced with the challenge of complying with new rules. Manufacturers can stay ahead of the curve and mitigate the impact on administrative efforts by:
1) Evaluating current lease obligations and determining which contracts will be affected;
2) Understanding the requirements of the reported obligation (including residual guarantees and return fees on existing and new leases); and
3) Completing a lease vs. loan analysis and verifying which provides a lower after-tax cost of use.
To transition successfully to a new era of lease accounting rules, a manufacturer’s financial advisor and equipment provider must be exceptionally well informed. With dependable guidance, manufacturers can easily comply with all changes and be positioned for success for years to come.
Peter Bullen is senior vice president of Key Equipment Finance’s Bank Channel. He can be reached at firstname.lastname@example.org or 216-689-8579.