Shifting Lanes: How Updated Lease Accounting Standards Are Affecting Dealerships
Note: This article originally appeared in The Showroom.
Most auto dealers participate in leasing in some way, whether they are leasing a building or equipment, operating as a lease here – pay here (LHPH), or are lessors of real estate. That means nearly all auto dealers will be impacted by the Financial Accounting Standards Board’s (FASB) update to the accounting standard for leases under U.S. generally accepted accounting principles (GAAP). The updated standard, which will take effect for private companies for fiscal years beginning after Dec. 15, 2019, will affect both lessors and lessees in different ways.
Changes to the lease accounting standard is far more sweeping and significant for lessees than for lessors. If your business enters into any lease of property, plant, or equipment – large or small – your financial statements will likely change. Currently GAAP requires lessees to classify leases as either capital leases or operating leases based on a series of economic tests. Lessees currently recognize assets and liabilities for capital leases only, while leases classified as operating leases remain off-balance sheet, with no recognition as an asset or liability.
The updated standard will require a lessee to classify leases as either finance leases (similar to capital leases under the current standard) or operating leases. All leases, except for those considered short-term leases under the guidance, will have to be recorded on the balance sheet with a right-of-use (ROU) asset and a lease liability. Consider the implications. A company leasing a building currently classified as an operating lease for three years from a third party for $23,875 per month currently has no asset or liability recorded on the balance sheet under current GAAP. Under the new lease accounting standard, that same lease is now required to be recorded as an $800,000 ROU asset and lease liability on the balance sheet (36 payments of $23,875 discounted at five percent). Adding $800,000 to both assets and liabilities can significantly change the complexion of the balance sheet.
The FASB’s primary goals of the new lease standard were to better align GAAP with international accounting standards, improve consistency in accounting for leases between companies, and improve the visibility of a company’s future off-balance sheet commitments by requiring them to be recorded on the balance sheet. While these goals may have been achieved with this new lease standard, they do not come without potential unintended consequences, including the cost and time associated with implementation. For instance, debt-based financial statement covenants embedded in lending arrangements (such as leverage ratios, debt-to-equity, or debt service coverage ratios) may be negatively affected by including operating lease obligations on the balance sheet. Some lenders are likely to lag in understanding and implementing changes into their lending agreements; it would be very prudent to begin talking to lenders now to ensure your covenants are adjusted so that implementation of this new rule will not negatively impact your compliance with debt agreements.
Very few changes were made to lessor accounting rules, as the FASB determined that the legacy rules were generally appropriate. The few targeted changes made to lessor accounting focus on aligning it with concepts recently released in the new revenue recognition guidance, Revenue from Contracts With Customers. The new leasing model and the revenue recognition model, effective for private companies in 2020 and 2019, respectively, underscore the principle of control transfer rather than the transfer of risks and rewards.
Lessors will continue to classify leases as operating, direct financing, or sales-type leases. Leveraged lease classification was not particularly common for private businesses and will no longer be an option under the new lease accounting standard. The most significant categorical change lies in the sales-type lease classification. Under the new lease accounting standard, the lessor must transfer control of the underlying asset to the lessee in order to qualify for sales-type lease treatment. This could make it more difficult to recognize both revenue and profit, which may affect certain LHPH operations. LHPH operators who have structured leases to recognize certain tax benefits while still recognizing sales-type treatment for GAAP will need to ensure the new guidance continues to support their position for book purposes.
The other significant change to the lessor model is what qualifies as initial direct costs (IDCs). IDCs are unique because they can be capitalized and deferred over the course of a lease for GAAP purposes. In the lease accounting standard update, FASB decided to restrain eligible IDCs to only costs incremental to entering into a contract. Incremental costs are those that would not be incurred if the contract had not been signed. Examples of incremental costs include sales commissions and contract printing fees.
The implementation of this new accounting change will be difficult for many. Considering the potentially significant changes to financial statements as it relates to leases, it is important for auto dealers to begin assessing current lease contracts and future obligations now.
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