Understanding Accounting for Leases
Accounting for Leases for Business Owners
Lease accounting can be tricky. New accounting standards require a lease to be recognized on the balance sheet as an asset and a liability. This can can present many challenges for businesses in determining the right steps in accounting for leases.
At face value, this new requirement makes a lot of sense. For example, when you lease a car, you are leasing the “right to use” the car and appear to own the car. If you appear to own the car, shouldn’t the car be treated as an asset to you and reported on your balance sheet?
The concept seems simple enough, right?
However in early June 2018,Accounting Today reported that less than 1% of companies had finished implementing the new lease accounting requirements. 79% of privately owned businesses had not started, or were still “assessing the impact”. For more information, check out the article and surprising statistics here.
Many businesses are still unprepared due to the complications in implementing the new standard. It has even been a struggle for accounting firms nationwide, especially in helping their clients determine which contracts qualify as leases, or may be leases in disguise. Other complications are how to account for these transactions and the effects on the financial statement bottom lines.
So, what’s the problem?
Right of Use Asset Value
After identifying a lease, determine the initial value of the underlying right of use asset.
Determining the value of a purchased asset is easy. The initial asset value is the purchase price. The value depreciates over time, or the asset’s useful life. The amount of depreciation expense each year then goes against the value of the asset, reducing its net value over time.
Let’s say you buy equipment for $21,000 and determine its useful life to be 7 years. You would write off $3,000 per year in depreciation expense ($21,000 / 7 years = $3,000).
With a leased asset, this concept is similar. However, there are additional accounting steps to apply compared to an owned asset.
Now let’s assume you lease the same equipment for 3 years and have the option to purchase it at the end of the lease for $1. This common form of equipment lease a $1 buyout lease. You expect to exercise the $1 buyout option with 4 years of life left on the asset.
Here is where it starts to get tricky….
The lease itself is “paying off’ the equipment in 3 years, with the amount left to repay the lease included on your Balance Sheet as a liability. After paying off the lease in 3 years, the liability will no longer be on the balance sheet.
The equipment, or right of use asset, is also on your balance sheet at current value. The asset will be used for 7 years (3 years leased and 4 owned) and amortized (depreciated) over the full useful period.
The total lease payment includes principal and interest. The amount related to principal is never classified as an expense with proper accounting. Instead these payments reduce the liability on the remaining lease principal left to pay.
The lease will be “paid” over 3 years. However, the asset will be“expensed” over 7 years. This timing difference creates differences in cash flow vs. net income.
Identifying Lease Contracts
Another issue is identifying what contracts are leases. This is because most business owners and their accountants are not aware of the service type contracts that may be leases in disguise. A few examples of common of unidentified leases are:
- A “service contract” for security services, which also includes the use of cameras and often recorded to security expenses.
- A two year cell phone contract, which also includes the cost of the phone in the monthly payments often recorded to phone expenses.
- A service contract for technology or office equipment, which also includes the use of computers, scanners, or printers and often recorded to office expenses.
The business is responsible for properly identifying leases.
There are millions of service type lease contracts out there, though most business owners or their accountants never needed to put much thought into identifying these items until now. Consequently, this is one of the largest reasons for slow implementation overall.
Other Lease Items to Be Aware Of
-Lease interest rate or effective interest rate
-Published useful life of the right of use asset vs. length of lease payments
-Terms of the lease and any additional liens stated in the “fine print”
-Is insurance required? Most leased assets require insurance or a surcharge will apply
-The value of the lease asset and liability – calculated as the present value of the lease payments
Businesses operating under Michigan’s Medical Marihuana Facility Licensing Act will need to implement proper lease accounting from the beginning. New businesses are in the best position to implement these standards right from the beginning. Proper lease accounting is nothing to fear and easily done with the help of a knowledgeable CPA. For any lease contract the business enters into, it should be fully aware of the accounting effects.
At LC Solutions Michigan PLLC, we know leases. Our staff has over 35 years of experience working with equipment leases and contracts.
Please contact us here for more information, or to schedule a consultation to discuss your business needs further.