Nearly every manufacturer leases equipment or real estate. For decades, companies were not required to report many lease-related assets and liabilities on their balance sheet. That is all about to change under a controversial new lease accounting standard that is scheduled to be published in early 2016. Companies should be proactive in analyzing their lease portfolio, particularly those with regulatory capital requirements such as bank covenant ratios.
Shifting the Reporting Paradigm
Under current U.S. Generally Accepted Accounting Principles (GAAP), companies are required to record lease obligations on their balance sheet if the lease is considered a financing arrangement, such as rent-to-own contracts for buildings or vehicles.
Currently, companies must consider various rules to determine if they have a capital lease. First, if the present value of lease rental payments amounts to more than 90% of the asset’s value, the contract is generally considered a capital lease and the asset and liability are placed on the lessee’s balance sheet. The other factors that force a balance sheet approach include a determination to see if the lease transfers ownership at the end of the lease term; if the lease agreement contains a bargain purchase option; or if the lease term is equal to 75% or more of the estimated economic life of the asset.
Under existing GAAP, if any of these conditions are present, the lessee must report the lease on the balance sheet as a capital lease. If these conditions are not met, the lease is generally considered an operating lease and the lessee simply records the payments as expenses on the income statement.
The current accounting rules give companies significant leeway to structure deals to look like rentals. Investors and lenders often complain that this practice makes lessees appear more financially secure than companies that take out loans to buy the same assets. For some companies — such as trucking companies that lease their fleets of vehicles or manufacturers that rent all their warehouse space — lease payments represent significant financial obligations.
In 2013, the Financial Accounting Standards Board (FASB) released Proposed Accounting Standards Update No. 2013-270, Leases (Topic 842), to change the way these obligations are reported. These standards were largely converged with an international standard with the same name.
The standards boards have since disagreed on several aspects of the project — in particular, how leases should be reported on companies’ income statements — and expect to publish separate final standards on leasing accounting in early 2016. However, both standards will focus on providing greater transparency in reporting future lease obligations.
Exempting Operating Leases
Manufacturers and distributors are especially concerned about the impact the new standard will have on their financial statements and the compliance burdens it will impose. They tend to rely heavily on fixed asset leases and, therefore, expect to suffer disproportionate adverse effects compared with companies in other industries. They are especially concerned that the new lease standard will upend loan covenants that require borrowers to maintain certain debt-to-equity ratios.
After fielding significant criticism, the FASB has decided to make its final guidance far less reaching than its 2013 proposal. It is expected to retain the requirement that companies record obligations to make payments on rentals of storefronts, equipment and vehicles as liabilities. However, the FASB has decided that certain operating leases — those with terms of 12 months or less that are more akin to rentals as opposed to financing deals — will continue to be accounted for on the income statement as they are today.
Implementation Date Postponed
As of this writing, the FASB is adding the finishing touches to its final standard on lease accounting. However, the board has announced that the revised guidance will not go into effect for public companies until annual periods beginning after December 15, 2018. Private companies will have an extra year to comply.
Despite this delay, proactive manufacturers should talk to a financial advisor today about how the lease standard is likely to affect their financial statements and debt-to-equity ratios in the future. Doing so can help preempt negative consequences related to this major change.
Sidebar: Why Lease?
When it is time to acquire new vehicles, equipment or warehouse space, manufacturers and distributors often wonder, “Should I lease it or buy it?” The revised accounting standard on leases makes leasing seem less advantageous. However, there still may be sound financial reasons not to buy an asset outright.
An equipment lease is essentially a financing arrangement in which another company owns the equipment and leases it to you at a flat monthly rate for a specified term. At the end of that term, you can opt to buy the equipment, return it or lease new assets.
Depending on how the contract is written, a lease may eliminate the need for a large down payment, reduce maintenance costs and reserve capital for other purposes. Leases also offer more flexibility in case the company moves in a different strategic direction than expected — or the equipment becomes technologically obsolete.
Taxes also should factor into the decision. The classification of leases for tax purposes generally aligns with current accounting practice. Operating leases are typically deductible as an operating expense. Conversely, capital leases provide tax deductions for depreciation, insurance, interest and repair expenses on equipment. For advice on whether to lease or buy, contact your financial advisor.
For more information on lease obligations, contact Nick Meno at 312.670.7444. Visit ORBA.com to learn more about our Manufacturing & Distribution Group.