Leveraging ASC 842 accounting for leases

As more companies consider conserving cash by investigating leasing and other financing options, understanding the intricacies of lease accounting standards becomes crucial, especially with generally accepted accounting principles known as GAAP.

ASC 842 GAAP accounting rules were developed to mirror international accounting standards, changing the accounting for some lease configurations that historically hadn’t appeared on balance sheets.

Impact of GAAP accounting changes

In general, the ASC 842 lease accounting standards, introduced over the course of recent years, improve transparency of off-balance sheet leases, increase comparability between companies with different lease operating models, and ultimately reduce off-balance sheet financing.

“For years, companies had been reporting leases under a different set of rules,” explains Pete Georgelas, director of business development, Capital Equipment Group, at U.S. Bank Equipment Finance. "Suddenly, all leases were going to be reported on balance sheet. As a result, our clients had to ascertain how they were going to manage reporting, not only future lease transactions, but leases they already had on their books."

The ASC 842 lease accounting rules were phased in for different kinds of entities. They went into effect for publicly held entities for fiscal years beginning after December 15, 2019 (2020 calendar year), but privately held entities received more time to adjust. For them, the new rules began for fiscal years after December 15, 2021 (2022 calendar year) and interim periods after December 15, 2022 (2023 calendar year).

“The lease accounting rules give companies a whole new set of factors to consider,” Georgelas says. “For example, under these rules, a sale-leaseback with a contractual fixed buyout option will poison the well for operating lease accounting treatment. Prior to the rules’ implementations, you could do a sale-leaseback with a contractual fixed buyout option and still structure it to technically be qualified as an operating lease. Under the lease accounting rules, this structure will be reported as a loan liability.” 

Read more: Finance or operating lease? Deciphering the legalese of equipment finance

>> Learn more: Contact us to discuss enhancing your equipment finance strategy.

Operating vs. finance lease in ASC 842

There are many ways to lease equipment, but in general, the structure is defined as either a finance lease or an operating lease.

• Operating lease: A contract allows for the use of an asset in exchange for rental payments but does not convey ownership rights of that asset. Organizations may use leasing as a cost-effective solution in the acquisition of equipment, optimizing and managing balance sheet ratios, such as leverage, ROE and ROA.
    
• Finance lease: A lease is determined to be a finance lease if it meets any one of the five defined lease criteria presented in ASC 842. Like the operating lease, in a finance lease, the lessor must grant the right to control the use of the asset to the lessee. The lessor must have control of the underlying asset to convey this right. Depending on the agreement, from a tax and legal perspective, a lessee may or may not be considered the asset owner. 

“The difference between a finance lease and operating lease is how it’s reflected in the financial statements. A finance lease is recorded like a loan – there’s an asset and a liability. In the financial statements, you disclose the interest and principal,” Georgelas says.

An important and meaningful difference for the expense recognition, besides interest expense vs. operating expense classification, is that the operating lease expense is a straight-line rent expense (easier for budgeting); finance leases have a front-loaded interest expense recognition. The total expense includes both an amortization expense and an interest expense.

Capitalizing an operating lease right-of-use asset

“An operating lease is different, as it is reflected as a lease obligation on the balance sheet and not reflected as debt,” Georgelas says. “In the financial statements, under ‘right-of-use, an operating lease may allow the lessee to capitalize their right of use asset at considerably less than the cost of the equipment.

“As a result, clients had to ascertain how they were going to manage reporting, not only future lease transactions but leases they already have on their books,” he says.
 

Interpreting the ASC 842 lease accounting rules

Those terms and classifications are at the heart of the change in GAAP accounting standards. The Financial Accounting Standards Board (FASB) began the transition in 2018 from ASC 840, which much like its predecessor FAS 13 had four tests for operating leases and listed them as footnotes rather than balance sheet entries. Under ASC 842, all leases show up on the balance sheet, and the new rules also determine how those leases are listed.

In general, the latest lease accounting rules mean:

• All leases longer than 12 months are on balance sheet
• Present value of the lessee’s lease payments are recognized as either debt for finance leases or other liabilities for operating leases.
• Service contracts are off balance sheet
   

“With a finance lease, the liability is classified as a debt obligation and impacts the leverage ratio,” Georgelas explains. “The lease payment for a finance lease is reflected in the financial statements as principal and interest, tantamount to a term loan.”

An operating lease, on the other hand, is not reflected as a financial asset & liability, but under a section titled “lease obligation,” so it doesn’t impact the leverage ratio. “Also, under the right-of-use portion of the operating lease, an end-of-term residual, that's not a payment obligation and is not reflected in the financial statements. Only the rent is,” Georgelas notes.

“There's a real benefit, especially on assets that have long economic life and value, in how that impacts not only the balance sheet but also the P&L and what the client is required to report.”
 

Weighing the options

When determining the proper structure for equipment financing, Georgelas suggests a financial manager weigh a client’s liquidity preference and tax optimization strategy along with balance sheet and financial metrics. He starts with three questions:

• What is the best structure from both a tax and GAAP accounting standpoint?
• What are the drivers your company is most interested in?
• What are you really focused on? Enhancing return on equity, enhancing return on investment, and/or managing leverage ratios and financial covenants?
  
  

"If one of your primary covenants is funded debt to EBITDA, you may not want an operating lease, because it may act counter to that specific formula," he explains. "If your primary driver is fixed charge coverage, liquidity or managing leverage, then the operating lease can provide tremendous value.”

Contact a U.S. Bank Equipment Finance specialist for more information.