By Mark E. Battersby / Published June 2019
Whether for equipment, other business assets, or even the property housing the pressure cleaning operation, lease and rental payments are frequently one of a business’s 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 quite a change from the existing treatment where many leases were once considered operating leases and rental payments were simply deducted as a current operating expense on the financial statements and tax returns. Although publicly traded companies were required to begin treating leases as liabilities as of December 15, 2018, privately-held businesses, including many pressure cleaning operations, have until 2020 to comply—plenty of time to renegotiate lease terms and plan to reap the potential benefits.
Historically, accounting for leases has long been pretty straightforward: Determine whether the transaction is a capital or an operating lease. For the latter, disclosure of operating lease amounts is considered a component of future commitments only, as these relationships are 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’s 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 balance sheet footnotes where they are now reported to the category of “liabilities.” A corresponding “right of use” asset gets reported on the asset side.
In addition to changing how lessees account for operating leases, 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, new lease 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.
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 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).
The biggest impact from this change is, as already mentioned, its effect on liabilities. Although the new standard contains some protection for lessees, the sudden spike in liabilities might well trigger a loan or debt covenant and have creditors knocking on the pressure washing operation’s door.
Fortunately, all of those liabilities will be offset by so-called “right-of-use” assets on the other side of the balance sheet. By adding more assets to the balance sheet, this new standard pushes the operation’s Return on Assets (ROA) number lower without any fundamental change in business operations.
In general, there are two methods for leasing: operating and capital leases. The vast majority of transactions are labeled as operating leases which, in the past, were treated like rental payments without the necessity of showing the the transaction on the balance sheet. In contrast, a capital lease is more like a loan, with the asset 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 pressure cleaning operation’s balance sheet as a “Right-of-Use” asset with a corresponding lease liability.
While the new leasing standard will require new accounting procedures and reporting, the benefits of leasing remain—and are perhaps even improved. Combined with changes in the tax laws, lease financing, with its wide range of inherent advantages, will continue to be a beneficial option for acquiring equipment and other needed business property.
Passed at the end of 2017, the Tax Cuts and Jobs Act (TCJA) did include a provision that severely limited the current deductibility of interest expense to only 30 percent of earnings. Fortunately, many pressure washing and other small businesses are exempt from this deduction ceiling.
A number of the TCJA’s other provisions favorably impacted equipment acquisitions and financing. For example, leasing allows a business unable to efficiently use 100 percent bonus depreciation to benefit from a reduced lease rate because the lessor can now claim the 100 percent write-off. Lessees may also reap an economic benefit simply by entering into sale-leaseback for an asset already fully expensed, since the gain would be taxed at the new favorable 21 percent tax rate for corporations.
Sale leaseback transactions, or “leasebacks” as they are more commonly called, are transactions in which a business sells an asset and leases it back for the long term. In other words, the pressure cleaning business continues to be able to use the asset but no longer owns it.
Among the advantage of leasebacks is that it enables a business to realize cash from existing business assets and equipment. 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, reap the many tax benefits of ownership of the property they lease back to the pressure cleaning operation.
Under the new ASC 842 standard, a leaseback transaction would not be considered a sale if (1) it does not qualify as such under other accounting standards, or (2) the leaseback is a finance lease.
Transactions which include a fixed price purchase option will, as mentioned, no longer be considered a “successful” sale and leaseback. A failed sale-leaseback occurs when:
This last item means any leaseback that includes a fixed price purchase option at the end will remain on the lessee’s balance sheet at its full value where it will be 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.
It is the rare business that doesn’t consider leasing as an option for financing equipment acquisitions for a variety of reasons, including the following:
All pressure cleaning businesses are required to show their lease agreements on the balance sheet as a Right-of-Use (RoU) asset and a lease liability, with a few exceptions. The related expense will then hit the income statement under two headings—amortization of the RoU asset and gradual and incremental long term interest growth on the lease liability.
The new standard is designed to improve and clarify the financial reporting of lease transactions and seeks to provide more transparency by changing the accounting view and the ways that a business accounts for future leasing transactions. Unfortunately, the new standard will not just have a direct impact on balance sheet and financial reporting, since its complexity will present many challenges.
Bottom line, the new rules should have no impact on a pressure cleaning 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 pressure cleaning business’s dealings with potential lenders, investors, and suppliers means starting now. And, as always, professional assistance is highly recommended.