By Mike Hammerslag
The lease vs. buy analysis has had a longstanding function in corporate finance. Historically, the allocation of capital has always been constrained and leasing has been a means by which asset decisions could be made without directly impacting the capital budget. The outcome of that approach was primarily, a cheaper leased asset, and secondly, the distinct benefit of its placement off balance sheet, and not as a “capital asset.”
Under legacy FASB accounting guidance, leases were kept off the balance sheet by avoiding classification as a finance lease under the capital lease test of FAS13, and later ASC 840. Similarly, on the international stage, under IASB accounting rule IAS 17, leases were not classified as a finance lease unless it qualified as such and had to be placed on the balance sheet of the company.
Under the new lease accounting regulations – formally announced at the beginning of 2016 as ASC 842 (under the guidance of the FASB) and IFRS 16 (under the guidance of the IASB) – all leases, subject to certain small exemptions, must now be placed onto the balance sheet regardless of classification.
Under the new IASB rules, only one lease classification was allowed. Under IFRS 16, all leases, subject to small exemptions, will be accounted for on the balance sheet as a finance lease, with operating lease treatment no longer an option.
Meanwhile, under the FASB rules, except for a few exemptions, there is a new capital lease test and the continuation of a two-classification model under which to account for a lease: the operating lease and the finance lease. Regardless of the test outcome, however, both lease types go onto the balance sheet.
Therefore, no matter which body a company reports under, your leases are going to appear on your balance sheet. What does that mean for the corporation’s capital and lease vs. buy decisions? It means that the decision is no longer between lease vs. buy or an outright purchase that is structured to avoid finance lease classification. Instead, companies must consider the lease vs. buy approach compared to a more expansive cost benefit analysis associated with the tracking costs of accounting for the asset.
It has been suggested by some industry pundits that purchasing formerly leased assets would be a sound strategy to avoid the costs of the new leased asset’s accounting rules, although purchasing the asset adds it on the balance sheet nonetheless (albeit in a slightly different fashion). With the assumption that a company is already optimally allocating its capital, it appears that there is no required change to business practices as a result of this accounting rule change. In other words, if a company is operating at its maximum benefit to shareholders and stakeholders alike under the old lease accounting rule, then under the new accounting rule, no change in strategy is necessary.
However, there is another perspective. Before the new standards, decentralized leasing may have resulted in multiple leases for the same product at several different prices. (Effectively, non-optimal leasing and non-optimal negotiating for those leases.) So, because of the new rules, the increased reporting will enable companies to gain greater insight into their lease portfolio, processes, decisions and overall performance. The increased scrutiny on leases – regardless of the new costs of reporting for them – may make leasing more efficient and even cheaper than before. And perhaps, leasing may increase. As these standards take effect, it will be interesting to see how companies choose to address their leasing and purchasing decisions.