In the portable storage business we talk about “renting” and “leasing” containers without really paying attention to the meaning. With renting we most often mean giving letting a customer use the container and pay a fee, each month or 28 days, until it is returned. What is meant by leasing isn’t always clear; but we ought to think about the difference between the two because accounting rules for leases are proposed to change.
Leasing has long been a way of providing financing for capital intensive operations at a much higher advance rate than traditional bank loans and more favorable terms of collateralization. One main reason is that the lessor retains the asset on his balance sheet and has some tax benefits in addition to the lease income. A lease is defined as a contractual agreement between a lessor and lessee that gives the lessee the right to use specific property, either owned by or in the possession of the lessor, for a specified period of time in return for stipulated, and generally periodic, cash payment.
The current reporting requirements for leasing has allowed companies to use leverage above what is considered economically prudent levels without informing its investor, lenders, insurers etc. In addition, the current structure of lease payments has given disputable tax advantages to both the lessee and the lessor. Furthermore, the current reporting requirements don’t show the true economic benefits of the use of the leased assets compared to owned assets on a company’s financial statement. Finally, current leasing rules are different between countries which make it difficult to understand the financial exposure of multinational companies.
To provide a more accurate financial picture of companies the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) announced a joint project to comprehensively reconsider lease accounting. The two boards’ stated intention is to recognize an asset and obligation for all leases as well as the benefit of use of a leased asset.
Why make changes?
From a legal perspective, leasing is merely the “rental” of property owned by the lessor. But from an economic perspective, many leases resemble seller-financed purchases of property. This is especially true when a lease agreement contains provisions that effectively transfer the benefits and risks of owning the property from the lessor to the lessee.
In a perfect world, financial statements would represent the economic substance of relevant transactions and events that affect a reporting entity regardless of the legal form of those transactions and events.
Current Leasing Standards
The accounting profession recognizes leases as either an operating lease or a capital lease (finance lease). An operating lease records no asset or liability on the financial statements, the amount paid is expensed as incurred. On the other hand, a capital lease is recorded as both an asset and a liability on the financial statements, generally at the present value of the rental payments (but never greater than the asset’s fair market value). Furthermore, one of the basic criteria1 is that the life of the lease is equal to or greater than 75% of the economic life of the asset.
Under an operating lease, the lessee records rent expense (debit) over the lease term, and a credit to either cash or rent payable.
Under a capital lease, the lessee does not record rent as an expense. Instead, the rent is reclassified as interest and obligation payments, similarly to a mortgage (with the interest calculated each rental period on the outstanding obligation balance). At the same time, the asset is depreciated. If the lease has an ownership transfer or bargain purchase option, the depreciable life is the asset’s economic life; otherwise, the depreciable life is the lease term. Over the life of the lease, the interest and depreciation combined will be equal to the rent payments.
1 The basic criteria for capitalization of a lease by a lessee are:
- The lessor transfers ownership of the bargain to the lessee at the end of the lease term.
- A bargain purchase option is given to the lessee. This is an option that allows the lessee, upon termination of the lease, to purchase the leased asset at a price significantly lower than the expected economic of the asset.
- The life of the lease is equal to or greater than 75% of the economic life of the asset.
- The present value of the minimum lease payments (MLP) is equal to or greater than 90% of the fair market value of leased property.
For both capital and operating leases, a separate footnote to the financial statements discloses the future minimum rental commitments, by year for the next five years, then all remaining years as a group.
As we can see in the chart below the current lease accounting rules shows neither the lessee’s full obligations under a lease agreement nor the benefit of use of the leased asset during the term of the lease. The new rules suggest that the lessee, on his balance sheet, recognizes the “right of use” of the asset during the term of the lease. The “right of use” is then expressed as the value of the asset at the inception of the lease on the balance sheet. The value of the “right of use” is expensed on the profit and loss statement by dividing the total lease payments minus the “right of use” by the term of the lease. Furthermore, the difference between the “right of use” value and the total lease payments is booked as “cost of use” or “interest” on the profit and loss statement.
The example below shows the different accounting methods for a three year lease with an original equipment cost of $30,000, at a lease rate of 8.3%2 equivalent to effective interest rate of 12%. The first section shows the new suggested lease accounting, the second sections shows the current traditional operating lease method and the third sections shows the accounting for a traditional loan.
First of all you can see that there is no difference in the overall payments between the three methods. Secondly you can see that there are no obligations shown when using traditional lease rules but very similar obligations shown when comparing the new lease rules to a traditional loan. Needless to say that makes sense since the objective with the change in the rules is that balance sheets should better express the asset and the obligation for the lessee.
2 How to calculate the lease rate (APR):
[Monthly Lease Payment] x [Term (months)] = [Total amount out of pocket] [Total amount out of pocket] – [Financed amount] = [Total finance charge] [Total finance charge] / [Term (years)] = [Finance charge per year] [Finance charges per year] / [Financed amount] = Annual Lease Rate
So what does the new leasing accounting rules mean for a portable storage business?
First of all it means a very clear distinction between how to deal with operating versus capital leases. The operating lease is a lease that is equivalent to a short term rental, 12 months or less. It will require more complex accounting when renting containers or other equipment for more than 12 months. Secondly, it means that all your future lease payments for trucks, trailers, cars, copy machines, computers etc will show as obligations on your balance sheet. That may or may not be an issue depending on if you have bank loans with covenants. If you do and the new lease rules make you “overleveraged” the bank could restrict use of credit lines etc. Most likely it will take some time for the rules to be put in place and if your banking relationship is good I wouldn’t worry about it.
I can’t see that the changes in rules will have much impact for the typical portable storage company. The companies that may be affected are those that have enjoyed rapid growth financed with leases and not have much equity on their balance sheets as well as have stringent covenants with their banks. Typically companies in the portable storage industry grow slowly, have low leverage and the value of their leases is low relative to the overall balance sheet.
Just be clearer with your customers, when you sign a rental agreement, don’t call it a lease, regardless of the length, it is still a rental agreement. Also, once the new rules are in place, talk with your CPA or tax advisor before entering into any lease agreements so that there is a clear understanding of how to account for them.