Lease Accounting Issues
What is an operating lease?
Years ago, the word "operating" actually meant that you got an operator along with the equipment, as well as fuel and other essentials to make the thing work. Now it is an accounting term referring to a lease that remains off balance sheet (as all leases used to be). Operating lease obligations are referenced in the footnote section of the financials and not in the Balance Sheet as assets and liabilities.
Given reasonable alternatives, most companies will opt for structuring equipment lease transactions to meet the accounting criteria for operating lease treatment. This reduces the level of debt on the books and improves key financial ratios, such as debt to equity. In addition, financial performance indicators such as return on assets (ROA) are also improved. The better the financials look, the easier it is to get needed financing in the future.
How do I get to an operating lease?
Start by reading over the article, "Tailoring an Operating Lease to Fit Your Company" and you'll see that there are literally dozens of ways to get there. The important thing is to realize that if you need one, you can get there.
The most difficult hurdle is usually called the "90% test", which essentially mandates that the lessor maintain a reasonably significant residual risk in the transaction. As the rate of change in what is considered state of the art in equipment technology has accelerated, the natural response by many lessors has been to shorten the lease terms as well. Unfortunately, a byproduct of this is larger and larger lease payments. The danger is that your company will end up with a lease structure that is preferable for accounting purposes but also carries a lease payment that is significantly higher than the budgetary requirements.
Although this is one response to the problem, it is certainly the least creative one. Suffice it to say that Leasing Ideas can assist you in structuring an operating lease without taking the payments higher and higher in an effort to do so. Using our structuring ideas may also help you get a few other items off the balance sheet, including software, which you would be hard pressed to accomplish on your own.
Aren't lease accounting rules changing?
Since 1996, various international accounting standards boards have been looking into changing the treatment for leases and effectively eliminating many (perhaps most) of the benefits currently attributed to the operating lease structure. In December of 1999 they released a further discussion paper, now being called the "G4+1 Paper" which is summarized on the ASB web site in the UK at www.asb.org.uk/publications.
While we think that a lot of the G4+1 recommendations make sense, we also know that we are dealing with not just national but international bureaucracies. As such, material changes to current accounting rules are likely to progress very slowly.
The bottom line would seem to be to enter into as many operating leases as possible now, when the benefits continue. If and when the Accounting Standards Boards changes things, they will probably phase in the changes over time and also "grandfather," or exempt from any adjustments, those lease transactions entered into before a future date.
How can I avoid accounting "surprises"?
Owned assets are depreciated based upon "useful lives" which were initially set nearly twenty years ago. In many cases, technology has changed far faster than the tax code. For example, computers are still estimated to have a useful life of five years and due to accounting conventions, the actual depreciation period is usually spread over six years. The problem is obvious, as most computers today lose any real economic value in the used computer secondary market in 24 to 36 months. In five or six years, they are usually referred to as "boat anchors".
Leasing assets of this type usually allow for more rapid write down, as the tax deductible lease payments are much higher than the depreciation benefits of ownership over the first two to three years. If you own the equipment, the depreciated "basis" of the equipment is likely to be much higher than true market value at this point in time, causing an asset write down on disposition which may not be desirable from a financial perspective.
Are there other accounting benefits to leasing?
For companies who are concerned about the alternative minimum tax (AMT) leasing is often a better alternative, as accelerated depreciation is a component of the "tax preference" items that work into the AMT calculation.
Even if a company's tax burden isn't quite down to an AMT level, keep in mind that if the lessor is in a higher tax bracket than you are, this can result in lower payments to you. Since someone can take the depreciation benefits, it might as well be the entity with the higher tax profile.
Article source: leasingideas.com
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