Understanding an Accounting Change for Leasing Equipment

A company can lease assets in one of two main ways: capital leases or operating leases (FMV). Prior to the new accounting standard, GAAP required the assets and liabilities associated with capital leases to be on a company’s balance sheet. Typically, these leases were recorded on the asset side of the balance sheet under Property, Plant and Equipment (PP&E) while the lease liabilities were recorded in Debt or Other Liabilities. From an income statement perspective, the annual cost of capital leases required the company to take depreciation and interest expense.

Operating leases, on the other hand, had the luxury of not requiring assets and liabilities being reported on the balance sheet. Because the operating lease did not convey any type of ownership to the lessee, it was kept off the balance sheet. The annual cost of operating leases were lease payments expensed on the income statement. This old approach benefited customers who were compensated on a Return on Assets calculation (lower assets mean higher ROA ratio).

The change does not affect capital leases. The asset and liability remain the same on the balance sheet and depreciation and interest costs are reported on their income statement. Customers still enjoy the ability to manage cash flow by spreading out the cost of their Tennant acquisition over time. The new standard is aimed squarely on operating leases. That’s because although there’s no ownership on the part of the lessee, they still have an obligation to make lease payments. Therefore, the intent of the change is to bring this obligation to the attention of investors, creditors and others who analyze financial statements. 

The biggest change is on the balance sheet. Customers now need to add an asset called a “right to use (ROU)” asset; and then add a corresponding non-debt, lease liability.  Both items are initially measured by the present value of the scheduled lease payments.  In most cases there will be limited affect to debt covenants. In other words, adding the operating lease to the balance sheet should not penalize companies who have strict debt restrictions from their lending institutions. From what we understand, this will be rare.  And secondly, customers should remember the payments are what’s going on the balance sheet, not the cost of the asset as required with the capital lease. The annual lease payment will be expensed as normal on the income statement.  

The new accounting change takes effect in 2019 for public companies and 2020 for private companies.