How Buy Here – Pay Here Dealers Can Prepare for the New Lease Accounting Standard
Since it was introduced nearly six years ago, the updated lease accounting standard has been amended and delayed. But 2022 is the year the updated standard finally takes effect for private companies, including buy here – pay here (BHPH) dealers. Here’s how the change could impact your dealership and a few steps you can take to prepare.
Lease accounting guidance in accounting principles generally accepted in the United States (GAAP) currently recognize leases in two ways:
- A capital lease, which effectively operates like debt with the asset and the corresponding liability recorded on the books of the lessee
- An operating lease, in which payments made for the usage of an asset are recognized as expense, but no asset is recognized on the balance sheet
In Accounting Standards Update (ASU) No. 2016-02, Leases (Topic 842), which is effective beginning in 2022 for private companies, the core principle is that a lessee should recognize the assets and liabilities that arise from leases. Lessees will be required to recognize a right-of-use asset and a lease liability on the statement of financial position for most leases at the commencement date, with exceptions provided for certain short-term leases.
The accounting applied by a lessor is largely unchanged from the previous application, and lessors should continue to recognize lease income for those leases generally on a straight-line basis over the lease term.
How Does This Impact Me?
Most BHPH dealers currently have operating leases under noncancelable lease agreements, which are currently not recorded as assets or liabilities on the balance sheet. Under ASU No. 2016-02, an asset and liability will likely need to be recorded. For dealers with multiple leases, there will be upfront and ongoing time and costs associated with implementation of the new standard in various areas, including identifying the leases, determining the lease term, and calculating the initial and ongoing entries for the right-of-use asset and lease liability.
BHPH dealers typically have bank borrowings and other lending agreements that contain financial covenants. If these covenants include leverage ratios or other financial metrics, the new lease amendments can impact these calculations due to the new asset and liability recorded on the balance sheet.
Additionally, many dealers lease the real estate where the dealership operates, and frequently this is a lease from a related party under common ownership. Dealers who do lease from related parties may have additional challenges implementing ASU No. 2016-02 since related party leases may not be as explicit regarding terms, which are critical to determining the value of the right-of-use asset and related liability.
Related Party Lease Considerations
Topic 842 specifically states that accounting for leases with related parties should be the same as for leases with unrelated parties. A lease under Topic 842 is “a contract, or part of a contract, that conveys the right to control the use of identified property, plant, or equipment for a period of time in exchange for consideration.” The standard allows for verbal or written contracts, and since related-party leases are more likely to operate under verbal agreements, it’s important to remember they should be assessed based on the legally enforceable terms and conditions of the lease. In verbal agreements, the history of the lease arrangement and the perceived intention of the leased asset should be considered when determining if the lease could qualify as short-term. In some cases, legal counsel may be necessary to determine the contract terms for verbal or related-party leases since terms that are not explicitly stated may still create enforceable rights and obligations. Additionally, the assumptions made in other areas of accounting must be consistent with any assumptions used under Topic 842. A great example of these would be the existence of leasehold improvements and the current and expected future usage of the leased asset by the lessee.
Related party lessors may be tempted to make all leases month-to-month to qualify as short-term leases, which can be excluded from Topic 842; however, the definition of short-term leases under Topic 842 is more complicated than this strategy suggests. A short-term lease is defined as a lease that, at the commencement date, has a lease term of 12 months or less and does not include an option to purchase the leased asset. Month-to-month leases, or “evergreen” leases, are not automatically considered short-term leases. The lease term calculation under Topic 842 does include consideration of any options to extend (by the lessee or lessor), which are likely to be exercised.
Companies will need to exercise judgment in determining how to structure the leases with related parties. The intent, estimates, and past practices related to the arrangement must be considered. Additionally, the lease term may involve significant judgment by management when determining if options to extend or terminate will be exercised. It’s possible that reducing the noncancelable lease period may increase the probability of exercising any options, thus leaving the calculated lease term under Topic 842 the same.
The most important steps now are to determine what leases exist, including related party leases. Management will need to document any key provisions of the lease arrangements and any significant judgments made in determining the lease term or the various conditions of the lease. Related party transactions will have disclosure requirements whether the short-term lease exclusion is elected or not. Robust documentation of the transactions will help to support any positions taken. Companies should consult with legal counsel in instances where there are questions about the legal enforceability of the contracts, which will be necessary to get the correct accounting under Topic 842. Lastly, companies should consider other existing debt and lending arrangements for possible impacts to current covenant calculations.
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