Whether it is equipment, other business assets or even the property housing the snow removal and ice management operation, lease and rental payments are frequently one of the largest recurring expenses. Soon, however, those leases will be required to 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 have long been considered operating leases and rental payments treated as currently deductible operating expenses on the operation’s financial statements. Publicly traded companies are already required to begin treating leases as liabilities, but privately held businesses recently received a one-year extension for compliance with all new accounting standards including the lease reporting requirements.
The Coronavirus Pandemic has brought to light the importance of having lease data, such as termination clauses, rent abatement and co-tenancy clauses. In volatile times such as these, every professional snow removal professional needs to be able to quickly identify their rights and obligations buried in their real estate and lease agreements. Prompt access to this information could unlock thousands of dollars in savings – and newly available funding.
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 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 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 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 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.
While the legal 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 sale of the identified property, plant or snow and ice 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).
HOW BIG THE IMPACT
The biggest impact from this change is, as mentioned, its effect on liabilities. The sudden spike in liabilities might trigger a loan or debt covenant and have creditors knocking on the snow removal or ice management 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 (ROA) (net income ÷ total assets). That pushes the operation’s ROA number lower without any fundamental change in business operations.
While the new leasing standard will require new accounting procedures and reporting, the benefits of leasing remain – and perhaps are improved. Combined with changes in the tax laws, lease financing with its wide range of inherent advantages, will continue to be a beneficial option of equipment acquisitions.
Passed at the end of 2017, the Tax Cuts and Jobs Act (TCJA) included several provisions impacting on equipment acquisitions and financing. After all, leasing allows any business unable to use 100% bonus depreciation, to benefit via a reduced lease rate since the lessor can claim the 100% write-off. Lessees may also reap an economic benefit simply by entering into sale-leaseback for an asset already fully expensed since the gain taxed on the sale (assuming 100% gain) would be taxed at the new favorable 21% tax rate for corporations.
Sale leaseback transactions or “leasebacks” as they are more commonly called, are transactions in which a snow removal 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 advantage of leasebacks is that it enables a business to realize cash from existing business assets, equipment, plant 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, reap the many tax benefits from owning the property they lease back to the snow and ice removal business.
Under the new ASC 842 standard, the leaseback transaction would not be considered a sale if (1) it does not qualify as a sale under other accounting standards, or (2) the leaseback is a finance lease. A repurchase option would result in a failed sale unless (1) the exercise price of the option is at fair market value and (2) there are alternative assets readily available in the marketplace. If the transaction qualifies as a sale, the entire gain on the transaction would be recognized.
Sales and leasebacks 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:
- Leaseback in classified as a finance lease, or
- A leaseback 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.
THE ECONOMIC BENEFITS OF LEASING
It is the rare business that doesn’t consider leasing as an option for financing equipment for a variety of reasons, including:
Tax Management. Leases allow lessees to more efficiently manage taxes. And, when they cannot utilize all of the deductions, the lessors often can and pass the benefits through via lower lease and rental rates.
100% Financing. A lease generally equates to 100% financing of equipment, software, and services with zero down payment.
Keeping Current. Keep up with technology by acquiring more and better equipment compared to loan financing. Risk is avoided 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. Freeing limited cash for other areas of the business, such as expansion, improvements, marketing, etc.
IT’S TRANSPARENCY ONCE AGAIN
The new lease standard is designed to improve and clarify the financial reporting of lease transactions. Bottom-line, the new rules should have little or no impact on an operation’s income statement and, thus, there should be no effect on debt covenants. However, classifying, recording, and reporting lease transactions will pose a problem in many snow removal contractors.
The new standard seeks to provide more transparency by changing the accounting view and the ways that a business accounts for leasing transactions. Every snow removal professional has a unique opportunity to reap dual benefits by gathering important data to save money during these uncertain times while preparing to meet the upcoming accounting changes for leases.
By properly managing lease data and financial statements, a snow removal and ice management business can avoid costly penalties, prevent rent overpayments and refinance leases – resulting in hefty cost savings given the expensive nature of real estate and equipment leases. As always, however, professional assistance is highly recommended.
Mark E. Battersby is Snow Magazine’s financial writer. He’s based out of Ardmore, Pa.