The Financial Accounting Standards Board (FASB) has issued a new standard on accounting for leases (ASU 2016-02), and these will need to be fully implemented by public companies in 2019 and by private companies in 2020. Certain aspects of the implementation and transition methodology is retrospective, and now is time to become familiar with the new terminology and the required changes. This article serves only as a working guide. You must obtain solid professional advice if and when you get down to details.
We will start with some definitions and then review four tables that highlight important similarities and differences.
Cash purchase. When you purchase for cash, you use cash resources. The availability and cost of the “owners’ equity” used to make the purchase depends on the health of the company balance sheet and the owners’ expectations regarding a return on their equity. The owners take the investment risk and enjoy all the risks and benefits of ownership.
Financed purchase. When you finance a purchase, you use a combination of internal funds and funds from a third-party lender. You enter into a time-based agreement to repay the principal and interest on the loan. This makes it a risky form of acquisition.
Finance lease. When you use a finance lease agreement, you do not acquire the machine. You acquire the right to control it and use it for a predefined period and commit to time-based payments. Finance leases are designed for situations where substantially all the risks and benefits of ownership are transferred to the lessee. A lease will be classified as a finance lease if it meets one or more of four criteria defined in ASU 2016-02.
Operating lease. Operating leases are all leases other than finance leases. They also give you the right to control and use the machine for a predefined period in exchange for a commitment to make a series of time-based payments. They are much more flexible than finance leases, but unlike finance leases, they do not transfer substantially all the risks and benefits of ownership to you as the lessee.
Rent. When you rent, you acquire the right to use the machine under clearly defined conditions. Rental payments are fixed and defined, but the rental period is relatively undefined. You have the risks and benefits of use, but you clearly do not have the risks and benefits of ownership.
We work in a dynamic world where work and workloads can change substantially. Flexibility is therefore an important part of the acquisition decision. We need to know how long we are going to use the asset, what it is going to cost us to enter into the deal and what it is going to cost us to exit the deal.
The first table focuses on the question of flexibility and residual value. You can see that finance leases confer many of the rights and obligations of ownership to the lessee. You also see that operating leases provide you with much more flexibility.
The principal reason why we enter into all these complex financial deals is that they help us improve our cash flow and keep our working capital for other perhaps more important and urgent needs. The second table summarizes the situation with regard to cash flow and fixed cost recovery risk. We see that financed purchase and finance lease options are very similar with the exception that finance leases do not require any or any substantial capital investment. We see rental as the least cash and least fixed cost recovery risk option.
Complex financial arrangements in equipment acquisition impact the balance sheet and the tax calculation differently. The third table summarizes the situation. Finance leases can be seen to be a careful balance between financed purchases and operating leases. You do not own the machine, but the transaction does impact your balance sheet and you do take depreciation allowances.
We have not discussed costs, because efficiencies and competition in the financial market tend to make these small. It is much more a matter of selecting the financing alternative that matches your situation, the utilization you are likely to achieve, and the risks involved in the work that lies ahead. The last table gives some guidance.
I would like to acknowledge substantial assistance from valued colleagues in the preparation of this article.
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