Lease Accounting in the Biotech Industry

Lease Accounting in the Biotech Industry

Equipment leasing isn’t widely practiced in biotechnology and the life sciences. In fact, this type of financing has historically been overlooked by scientists and entrepreneurs in the sector.

In the face of shrinking budgets and tighter capital markets, however, equipment leasing is more easily identified as a solution in an industry that is often highly capital-intensive. It gets you the equipment you need to operate at the highest level and preserves more capital for you to spend on R&D, hire more scientists, purchase essential supplies and consumables, and extend your cash runway during tough economic periods.

Equipment leasing is a viable option for both early-stage biotech startups and more established labs, making lease accounting just as important. However, this is a topic that can often feel mysterious or confusing, especially because we often have others do it for us. (That is, unless you’re an accountant.)

In this article, we will provide an overview of lease accounting, explain its importance from a bookkeeping and compliance perspective, and review the benefits of equipment leasing in the life sciences. The overview includes:

  • Lease definition under ASC 842
  • Lease accounting definition
  • Lease accounting standards overviews
  • The importance of lease accounting
  • Equipment leasing‘s benefits in the life sciences

Before you do any accounting of your own, consult a tax professional. A CPA will be able to guide you through the lease accounting process or take care of the matter for you, helping you avoid any accounting mistakes.

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Lease Definition

Before you begin accounting for something as a lease, it’s important to define whether or not you have entered a lease contract. If you don’t have a lease on your hands, then accounting for one doesn’t make any sense.

Simply put, a lease is defined as a type of contractual agreement that outlines the “terms under which one party agrees to rent an asset from another party.” The party doing the renting is referred to as the lessee, while the owner of the asset is referred to as the lessor.

Assets that are leased generally include real estate, vehicles, and various types of business-related equipment. When the leased asset is a piece of equipment or machinery, you’ll often see the lease referred to as an equipment lease.

However, the technical definition of a lease is explained in the latest accounting standard issued by the Financial Accounting Standards Board (FASB), ASC 842.

The standard defines a lease as a contract, or part of a contract, that “conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration.”

Furthermore, the standard goes on to state that “a period of time may be described in terms of the amount of use of an identified asset (e.g. the number of production units that an item of equipment will be used to produce).”

From there, there are a number of other factors that can be used to determine whether a contract is a lease.

However, generally speaking, if the lessee has the right to obtain functionally all of the economic benefits from use of the asset, the right to direct use of the asset, and the asset is specified in the contract, then you are entering into a lease agreement.

Types of Leases: Operating & Capital

After you enter into a lease agreement, you’ll decide with the lessor what type of classification the lease falls under. When it comes to equipment leasing, there are two types of lease classifications available: operating leases and capital leases.

Prior to the introduction of the Financial Accounting Standards Board‘s (FASB) accounting standard, ASC 842, there were some notable differences between the two leases from an accounting perspective under the old standard, ASC 840.

Specifically, operating leases were seen purely as rentals, and were accounted for as such. This meant they were treated differently than a capital lease, only showing up on the income statement as an operating expense, with no liabilities or assets being listed on the balance sheet.

In contrast, capital leases, referred to as finance leases under ASC 842, were accounted for as if they were a purchased asset, showing up on the balance sheet as an asset and a coinciding liability.

Further, capital leases included the transfer of ownership at the end of the lease term, with the characteristics of ownership rights being taken into consideration for accounting purposes at the commencement of the lease and during its duration. Because of that, the capital lease can be amortized on the balance sheet.

However, with the introduction of ASC 842, the differences have been lessened, and the two lease classifications have become more similar. Both lease agreements represent the lessee’s right to use a rented piece of equipment for a specific period, paid for through monthly, quarterly, or annual lease payments, and accounted for on the balance sheet.

Learn more about the differences between operating leases vs. capital leases, as well as other types of equipment leases.

Lease Accounting Definition

Lease accounting is a method companies use to record the financial impacts of their leasing activities. Leases that meet specific classification requirements (i.e., whether a lease is an operating lease or a capital lease) must be recorded on a company’s financial statements in the correct way. It is regulated by a number of regulatory organizations, who separately develop and issue standards and practices to follow.

The financial statements where lease accounting shows up and makes an impact can include the balance sheet, income statements, and cash flow statements:

  • Balance Sheet: Reports a company’s assets, liabilities, and shareholders’ equity at a certain point in time. Assets represent what the company owns, while liabilities and equity illustrate how those assets are financed.
  • Income Statement: Reflects the ongoing operations of a company and shows how it realizes net profit after taking into account all revenue and costs over a specific period.
  • Cash Flow Statement: Includes operating, investing, and financing sections, looking purely at cash balance. Each section covers a specific measurement of cash inflows and outflows.

Depending on the classification, a leased asset and the various components of the lease contract will need to be accounted for on a specific financial statement or statements.

Without proper lease accounting, a company will have a difficult time understanding the impact its leased assets have on its overall financial health, nor will it have a clear idea of the total value of its assets.

There are differences between lessee accounting and lessor accounting. However, we focus on the former in this article, since you are most likely looking to lease equipment for yourself, rather than lease equipment to another company.

Leasing Standards Overview: New vs. Old

There are a number of regulatory bodies that oversee accounting in the US and internationally. The three we will focus on here include the Financial Accounting Standards Board (FASB), Governmental Accounting Standards Board (GASB), and International Financial Reporting Standards (IFRS), the umbrella organization of the International Accounting Standards Board (IASB). The standards are as follows:

The FASB creates and issues financial accounting standards intended to promote financial reporting, helping non-governmental and private companies properly report business activities and providing useful information to investors and users of financial reports.

The GASB operates similarly to the FASB, however, it sets standards and practices for state and local government entities that adhere to Generally Accepted Accounting Principles (GAAP or US GAAP).

The IFRS, on the other hand, provides standards and practices for companies that operate internationally.

While all three of the latest standards issued by these regulatory bodies can apply to how you account for your leased assets, the most important is perhaps ASC 842, which affects privately-held companies.

ASC 842 Overview

The new lease accounting standard, ASC 842, Leasing, was issued by the FASB, and replaced the older version, ASC 840. It took effect in January 2019 for public companies and on December 15, 2021 for private ones.

It changed the way in which companies account for operating leases, but did not make many changes to how capital leases, now known as finance leases, are reported.

Operating leases have historically been considered rentals from an accounting perspective, and the lease payments that go towards them were reported as operating expenses, thus being recorded on the income statement.

This meant they were not required to be included on a company’s balance sheet, making operating leases a type of off-balance-sheet financing. Under ASC 842, this has changed somewhat.

Operating leases are still considered a type of rental, shown on the income statement, but now must also be recorded on the balance sheet, represented as a right-of-use asset under the balance sheet’s assets section and as a lease liability under its liabilities and shareholders’ equity section. Despite this change, an operating lease’s liability is still considered an operating liability.

This has always been the case with capital leases, also known as finance leases. They are not recorded on the income statement, only show up on the balance sheet, and are treated like a purchased asset, meaning their liabilities represent debt.

GASB 87 Overview

As I’m sure it’s easy to guess, GASB 87 was issued by the GASB. It replaced GASB 13 and 62, providing a more accurate report of lease obligations and increasing the usefulness of governmental financial statements.

It’s likely you’re not a government entity, so this standard won’t apply to you. However, if you are, it’s an important one to know about its stipulations. Take the time to learn more about GASB 87.

IFRS 16 Overview

IFRS 16 applies to companies that operate internationally, and was issued by the IASB, going into effect January 1st, 2019. It replaced IAS 17 and, most importantly, eliminated the distinction between operating and capital lease classifications.

Under IFRS 16, a single model approach exists instead, whereby all lessee leases are reported as finance leases. The finance leases are capitalized and recorded on the balance sheet as a right-of-use (ROU) asset and liability. This change results in recognizing both depreciation and interest expenses on the income statement.

Companies that are dually reporting under both IFRS 16 and ASC 842 will see that the requirements under IFRS 16 resemble the accounting requirements laid out under ASC 842. That said, ASC 842 still includes the operating lease classification.

The Importance of Lease Accounting

Lease accounting is important for a number of reasons, with the most obvious being that it is legally required. If you fail to accurately report your leasing activities, you’ll find yourself in hot water with the IRS come tax season, and the SEC, if and when you go public.

Besides being legally required, you will both want and need to keep track of your leasing activities to understand the impact your leases are having on your company’s financial health.

If you lease, you need to keep track of activities to understand the impact on the company’s financial health. Ultimately, keeping track of these activities can help you run an organized and successful business.

How Does Equipment Leasing Benefit the Life Sciences?

There are several benefits equipment leasing offers to companies in every industry. But, we want to take a particularly specific look at how leasing can benefit startups and more mature companies in the life sciences.

When you lease your lab equipment with Excedr, you can:

  • Eliminate or greatly reduce the upfront costs that come with purchasing equipment.
  • Make the most of scheduled payments that are typically more flexible than loan payments.
  • Minimize equipment downtime with complete repair coverage and preventive maintenance.
  • Take advantage of potentially 100% tax deductible payments, providing you with significant cash-savings in the form of tax deductions. (This depends on your individual tax situation. Consult with your tax advisor if you’re eligible.)
  • Expedite the administrative work needed to procure scientific equipment.
  • Conserve working capital, helping you reinvest in your core business and operations, such as staffing, inventory, clinical trials, and marketing or sales efforts.

Parting Thoughts

Equipment leasing in any industry offers distinct benefits, and this is just as true in the life sciences and biotechnology. Equipment leasing programs like Excedr's can help your business conserve working capital, extend cash runway, and reinvest in other core areas of business, ultimately helping you grow while accessing expensive scientific equipment.

This makes leasing an excellent option during market downturns as well, when cash reserves are most likely going to be tapped. When capital markets shrink, being smart with your cash is even more important. Leasing is just one option available to you to spend your money more wisely.

If you are planning to lease lab equipment, or already lease, you will want to familiarize yourself with lease accounting and its importance, regardless of whether you or a tax professional are the one preparing your financial statements.