How Are Lease Rules Changing?
Big changes are coming to the world of leasing, but for those of us without accounting certification, these changes might appear a bit arcane. In this article, we’ll give you a zoomed out view of what’s changing and give you a few resources for further reading on the topic.
Table of Contents
Why Are Things Changing?
Currently, as many of 85 percent of leasing commitments go unreported, leading to a call from investors for regulatory bodies to update their leasing standards. Ostensibly, the changes are meant to make leasing activities more transparent and accountable.
Who Is The FASB?
The Financial Account Standards Board was established in the early 70s to help standardize accounting practices in the U.S. These generally accepted accounting principles (GAAP) are used, in turn, by the Securities and Exchange Commission (SEC) to establish accounting standards for public companies.
Though they have an enormous impact on policy, the FASB is a private, non-profit entity.
Before we get to why they’re making changes, here’s a quick overview of how things currently work with leases.
What Is An Operating Lease?
Chances are (unless you do a lot of leasing), when you think of a lease, you’ll be thinking of an operating lease.
Sometimes referred to as a “true lease,” an operating lease is essentially a form of rental agreement where you, the lessee, pay a monthly fee to use another party’s (the lessor’s) assets for an agreed- upon term. At the end of the term, the lessee usually has the choice to buy or return the asset or renew the lease.
In the past, this kind of lease came with some accounting advantages for lessees: the asset never had to show up on your books, and you could write off your lease payments as operating expenses.
What Is A Capital Lease?
Capital leases, on the other hand, tend to function as alternatives to loans. The lessee is essentially purchasing the product they’re leasing and the lessor is offering financing. The title of the asset passes to the lessee, who assumes all the responsibilities and liabilities for that item.
Traditionally, you have a capital lease if:
- You can buy the product at the end of your lease term for a well-below market value price ($1, for example).
- The current value of your lease payments is greater than 90 percent of the fair market value (FMV).
- The title automatically passes to you, the lessee, by the end of the term.
- The length of the lease exceeds 75 percent of the useful life of the equipment.
New lease laws will take effect after December 15, 2018 for public companies and a year later for private ones. Under the updated standards, capital leases will continue more or less unchanged but will be referred to as “finance leases” in FASB documentation.
Operating leases, on the other hand, will see significant changes under the new GAAP. Lessees with operating leases that last longer than 12 months will have to recognize those leased assets on their balance sheets. The liability will be equal to the current value of the lease payments. (Operating leases will, however, continue to be a straight-line expense, unlike capital/finance lease expenses.)
There will also be significant changes to the way sale-leaseback transactions are handled, but that is outside of the scope of this article.
What Effects Will This Have?
Companies that relied on keeping leased assets off their books will have to cope with the consequences of declaring those assets and liabilities.
How this will affect your company’s taxes and debt obligations precisely is a question for your accountant, but companies that make use of longer-term operating leases should start implementing systems to make sure they can accurately report their leased assets.
If your company relies on operating leases for a large amount of its equipment, you should begin building a strategy to account for those assets and the costs associated with doing so. If you’re interested in doing a deep dive into the upcoming changes, you can read more on the FASB’s website.