Rethinking your equipment purchasing approach

By |  August 21, 2019

Lease financing, with its range of inherent advantages, will continue to be a beneficial option when acquiring equipment. Photo courtesy of Keestrack

Whether equipment, business assets or even the aggregate plant, lease and rental payments are frequently one of a business’ largest recurring expenses.

Soon, however, those leases must be listed as liabilities on the balance sheet – suddenly visible to potential investors, lenders and suppliers.

This is a change from the existing treatment where many leases were considered operating leases and rental payments simply deducted as operating expenses on the financial statements. Although publicly-traded companies were required to begin treating leases as liabilities as of Dec. 15, privately-held aggregate operations have until 2020 to comply, providing plenty of time to renegotiate lease terms and plan to reap the potential benefits.

Accounting for leases

Historically, accounting for leases has been straightforward: Determine whether it is a capital or an operating lease.

For the latter, disclosure of operating lease amounts was considered a component of future commitments only, as these relationships were classified as “off-balance sheet.”

This off-balance sheet treatment has long created a challenge for investors and lenders as they attempt to understand a business’ financial obligations and future profit potential.

The culmination of years of debate, the new lease standard (ASC 842, Leases) requires businesses to move the future costs of their operating leases from the footnotes where they are now reported to the category of “liabilities” on the balance sheet. A corresponding “right to use” asset gets reported on the asset side.

In addition to changing how lessees are accounted for, the Financial Accounting Standards Board (FASB), the organization responsible for establishing accounting and financial reporting standards, also changed how leases are identified.

According to the FASB, a lease is defined as a contract – or part of a contract – that conveys the right to control the use of identified property, plant or equipment (an identified asset) for a period of time in exchange for consideration.

In contrast, the ASC 842 standard defines a lease as an agreement conveying the right to use property, plant or equipment (land and/or depreciable assets), usually for a stated period of time. Close, but no cigar.


The new lease standard enables producers and contractors to realize cash from existing business assets, equipment, plants and machinery. Photo by Zach Mentz

While the definition of a lease appears substantially the same, ASC 842 significantly changes how leases are identified. Under ASC 842, a contract is, or contains, a lease “if the customer (lessee) has the right to obtain substantially all of the economic benefits from the use of the identified property, plant or equipment (PP&E) and the right to direct the use of the identified PP&E throughout the time that the identified PP&E will be used to fulfill the contract with the customer (lessee).”

Measuring the impact

As mentioned, the biggest impact from this change is its effect on liabilities. The sudden spike in liabilities might trigger a loan or debt covenant and have creditors knocking on the operation’s door.

Fortunately, all of those liabilities will be offset by so-called “right-to-use” assets on the other side of the balance sheet. By adding more assets to the balance sheet, this new standard increases the denominator when calculating return on assets (net income divided by total assets equals ROA).
That pushes the operation’s ROA number lower without any fundamental change in business operations.

When a lease is a lease

The vast majority of leases are operating leases which, in the past, have been treated like rentals with payments considered operational expenses and with the transaction kept off the balance sheet. In contrast, a capital lease is more like a loan because the asset is treated as being owned by the lessee so it stays on the balance sheet.

Until now, only leases that led to the purchase of the asset were accounted for in this manner. Today, all leases with a term of more than 12 months must be present-valued and recorded on the aggregate operation’s balance sheet as a “right-to-use” asset with a corresponding lease liability. This includes leases for partial assets, including the portion of a shop, warehouse or leased office space.

The upside

While the new leasing standard will require new accounting procedures and reporting, the benefits of leasing remain and are perhaps improved. Lease financing, with its range of inherent advantages, combined with changes in the tax laws, will continue to be a beneficial option of equipment acquisitions.

The Tax Cuts & Jobs Act (TCJA), passed at the end of 2017, included provisions impacting the tax treatment of equipment acquisitions and financing. Under the TCJA, for example, current deductibility of interest expense is limited to 30 percent of earnings – with small aggregate operations exempt from this deduction ceiling.

Leasing allows a producer unable to efficiently use 100 percent bonus depreciation to gain the benefits via a reduced lease rate since the lessor can claim the 100 percent write-off. Lessees may also reap an economic benefit simply by entering into sale-leasebacks for an asset already fully expensed because the gain resulting from the sale would be taxed at the favorable new 21 percent tax rate for corporations.

Sale leasebacks

Sale leaseback transactions, or “leasebacks,” are transactions in which a business sells an asset and leases it back for the long term. In other words, the business continues to be able to use the asset but no longer owns it.

Among the advantages of leasebacks is that they enable producers to realize cash from existing business assets, equipment, plants and machinery. The cash gained can be used for many purposes, including business acquisitions or simply providing extra working capital. The buyer, often the operation’s owner or key employees, reaps the many tax benefits from owning the property they lease back to the business.

Under the new ASC 842 standard, the leaseback transaction would not be considered a sale if it does not qualify as a sale under other accounting standards or if the leaseback is a finance lease. A repurchase option would result in a failed sale unless the exercise price of the option is at fair market value and there are alternative assets readily available in the marketplace. Naturally, if the transaction qualifies as a sale, the entire gain on the transaction would be recognized.

Sale and leasebacks, which include a fixed price purchase option, will no longer be considered a “successful” sale and leaseback. A failed sale-leaseback occurs when either a leaseback is classified as a finance lease or includes a repurchase option that is at other than the asset’s fair value determined on the date the option is exercised.

This last item means that any sale and leaseback that includes a fixed price purchase option at the end will remain on the lessee’s balance sheet at its full value and classified as a fixed asset rather than as a right of use asset. Even though an asset may have been legally sold, a sale is not reported and the asset is not removed from the lessee’s balance sheet if these conditions exist.

Economic benefits to leasing

It is the rare business that doesn’t consider leasing as an option for financing equipment acquisitions for a variety of reasons, including:

Tax management. Leases allow lessees to efficiently manage some of their taxes. When they cannot utilize all of the deductions, the lessors can pass benefits through via lower lease and rental rates.

100 percent financing. A lease generally equates to 100 percent financing of equipment, software and services with zero down payment. Best of all, less than 100 percent shows on the balance sheet.

Keeping current. Maintaining technology by acquiring more and better equipment compared to loan financing and avoiding residual risk because that risk is assumed by the lessor.

Cash flow management. Smaller, more manageable and flexible payments while the equipment generates the revenue.

Cash savings. Save limited cash for other areas of the business, such as expansion, improvements and marketing.

Return to transparency

The new accounting standard is designed to improve and clarify the financial reporting of lease transactions. The new lease standard also seeks to provide more transparency by changing the accounting view and the ways producers account for future leasing transactions. The new standard will not only have an impact on balance sheets and financial reporting, but its complexity presents many challenges.

The new rules will have no impact on an operation’s income statement and, thus, there should be no effect on debt covenants. In fact, the FASB has specifically stated that the lease liabilities created by capitalizing leases should not be considered debt by most financial institutions.

Of course, adopting the new standard, complying with the new definitions for lease transactions and ensuring a minimal impact on the operation’s dealings with potential lenders, investors and suppliers means starting now.

Mark E. Battersby is a freelance writer who has specialized in taxes and finance for the past 25 years.

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