Operating Leases & How They Are Accounted For Under ASC 842
With the rising costs of technology, it can be challenging for labs to purchase new equipment with cash. To make matters worse, budgets have shrank or frozen and fundraising and borrowing has become a much more arduous (and often fruitless) undertaking.
When there is no room in the budget to purchase instruments with cash, labs can try and rely on financing to get the equipment they need instead. But certain options, such as drawing on a line of credit or taking out a loan, aren’t always viable choices. Instead, laboratories can lease the equipment they need to scale operations or replace obsolete equipment.
Not only can leasing give you access to the equipment you need to scale operations, accelerate R&D, and meet higher demand, it can provide companies with a way to maintain a positive cash flow, preserve working capital, and extend cash runway.
If a lab does decide to lease equipment, there will be, in general, two types of leases available to them: an operating lease or a capital lease.
In this article, we’ll review:
- What is an operating lease?
- How do you account for an operating lease under ASC 842?
- How can these types of leases help your business?
Which type of lease you end up with is up to you, but, lease classification itself is guided using criteria laid out under accounting standards like ASC 842, published by the Financial Accounting Standards Board (FASB), and US Generally Accepted Accounting Principles (GAAP).
If you’re thinking of leasing lab equipment, understanding each lease type will be critical for a few different reasons. For one, the accounting methods used for each will impact your company’s taxes and financial reporting. Additionally, knowing the unique characteristics of each lease can make decision-making simpler when it’s time to sign a lease.
Operating Lease Definition
An operating lease is a contract, or lease agreement, where the owner of an asset (the lessor) grants the holder of the lease (the lessee) the rights to use that asset for a specific period of time. It can also be referred to as a fair market value (FMV) lease or rental.
An asset, in the business sense, can be defined as “anything of value or a resource of value that can be converted into cash.” Examples include office equipment, industry-specific machinery (such as lab equipment or heavy equipment), various vehicles and aircrafts, and real estate and property. In this article, when we say asset, we’re referring to any piece of equipment that can be used to generate revenue.
The term “fair market value lease” can be used to describe an operating lease because, at the end of the lease, the lessee has the option to purchase the equipment at “fair market value.”
The term “rental” can also be used because, similar to a rental, an operating lease can be short-term, lasting 12 months or less, and is accounted for similarly on the income statement. However, an operating lease can also be long-term, covering more than 12 months and upwards of 5 or 6 years depending on the company you are leasing through.
Under the guidance of the US GAAP, there are two types of lease classifications: operating leases and capital leases.
Each type is classified based on criteria laid out in the lease accounting standard, ASC 842, Leasing, which replaced the previous standard, ASC 840, and was created by the Financial Accounting Standards Board (FASB).
Prior to the update, which occurred in 2016, the major difference between a capital lease and operating lease was the accounting treatment of each lease. While there are still some differences, namely the transfer of ownership rights, the new standard has made the treatment of these leases more similar.
A typical operating lease structure can contain different terms, but every contract will include the details regarding your monthly payment amounts owed for the use of the asset, security deposit, and first month’s payment.
Furthermore, operating leases (like those offered through our leasing program) will often provide end-of-lease options that give you the choice to:
- Return the equipment (free of charge)
- Renew at a discounted rate
- Or purchase of the equipment for the fair market value (FMV)
At Excedr, we believe in providing these choices to our clients because it gives them more flexibility at the end of the lease term. However, not every operating lease will include end-of-term options (ETO) like these.
Operating Lease Characteristics
Operating leases are characterized by the accounting method used to account for the lease payments and leased assets, which, as mentioned, was updated according to ASC 842 (we’ll review this in more detail later).
Historically, this type of lease treats the payments towards the asset as operating expenses, which are recorded on the income statement. While this is still true, ASC 842 also requires the expenses to be listed as liabilities on the balance sheet and the leased asset to be accounted for as a right-of-use (ROU) asset.
Operating leases are also characterized by the lack of transfer of ownership rights. That is to say, under an operating lease, the lessor remains the owner of the asset during and after the entire duration of the lease term. The lessee may have the option to buy the asset at the end of the lease term for the fair market value price, however, this changes the way in which the asset is accounted for going forward.
Classifying an operating lease under ASC 842 is somewhat similar to ASC 840. The lease still needs to meet specific criteria laid out under the accounting standard to exempt it from being recorded as a capital lease.
However, under ASC 842, certain “bright lines” have been removed from the test to foster a more principles-based approach to the accounting treatment (more on that later). In addition to removing the bright lines, a new question was added to the test, clarifying whether or not the asset is highly specialized.
Under ASC 842, an operating lease is classified as such so long as none of the following conditions are met:
- Transference of title/ownership to the lessee: there is a transfer of ownership of the underlying asset to the lessee by the end of the lease term.
- Bargain purchase option: the lease arrangement grants the lessee an option, which is reasonably certain to be exercised, to purchase the asset at the end of the lease for a price that is well below its FMV.
- Lease term: the lease term lasts longer than the major part of the asset’s remaining economic life.
- Present value: the present value of lease payments, plus any applicable residual value guarantee, is greater than or equal to “substantially all” of the FMV of the asset.
- Asset specialization: the asset is so specialized that it is expected to have no alternative use to the lessor at the end of the lease term.
In other words, if there is:
- No transfer of ownership.
- No bargain purchase option.
- The lease term is less than the major part of the asset’s remaining economic life, or lifetime value.
- The present value of the lease payments, plus any applicable residual value guarantee (RVG), equals less than the FMV of the asset.
- The asset is not so specialized it can’t be used after the lease term.
Then the lease will, by default, be classified as an operating lease. On the other hand, if one of these conditions is met, such as the transfer of ownership, then the lease will be classified as a capital lease for accounting purposes.
Accounting for an Operating Lease
As mentioned, lease payments under an operating lease are considered operating expenses, and are expensed on the income statement, similar to how rental expenses are accounted for.
ASC 840, the previous accounting standard, did not require these expenses to be recorded on the balance sheet, nor did it require the asset to be listed, leading to eventual criticism of the treatment.
Because ASC 840 did not require the same accounting treatment ASC 842 requires, operating leases were considered a type of off-balance-sheet financing. Simply put, off-balance-sheet financing allows companies to keep financing provided by leases off the balance sheet.
In doing so, companies could keep their debt-to-equity ratios low by treating lease payments as operating expenses, allowing the company to keep the capital it spent on assets, and the assets’ associated liabilities, from being recorded on the balance sheet. This accounting treatment would result in greater flexibility in future financing decisions, potentially cheaper borrowing, and the prevention of breaching loan covenants.
However, users/reviewers of financial statements weren’t able to glean insights from the statements that provided the full picture when it came to a company’s true financial position regarding risk and liabilities.
In some cases, companies’ leases amounted to major obligations for the lessees that were not reported as the debt-type liabilities that they resembled, which made it difficult to compare companies financing their operating assets through rentals versus companies financing through debt.
The previous standard, ASC 840, only required capital leases to be recorded on the balance sheet. This meant operating leases did not need to be recorded, which ultimately led to problems, such as lack of transparency regarding a company’s liabilities.
To reconcile this discrepancy, FASB created ASC 842, which requires companies to report the asset and its associated liability on the balance sheet, providing greater transparency for lease accounting.
FASB requires, under ASC 842, that every lease—except for short-term leases less than 12 months—be included on the balance sheet along with a lease liability and a right-of-use (ROU) asset.
A lease liability represents the lessee’s obligation to make lease payments and is calculated as the present value of all known future lease payments. The ROU asset represents the lessee’s authority to use an asset under the lease agreement, and is measured as the lease liability’s starting amount plus any lease payments made to the lessor before the lease commencement date, plus any initial direct costs incurred, minus any lease incentives received.
The leased asset is represented as a right-of-use (ROA) asset, which signifies the benefits the asset provides over the term of the lease, while the payments are represented as a liability showing the amount owed under the lease agreement.
Now that operating leases realize a liability and asset on the balance sheet, the total assets and liabilities of a company increase. There is little to no impact on debt when transitioning to ASC 842 from previous standards. However, you should consider how the new operating liability can possibly impact financial ratios.
That said, the tax benefits of operating leases remain. What FASB set out to accomplish with ASC 842 was to simply create more transparency to lease accounting.
How Operating Leases Can Help Your Lab
Now, you might be asking yourself: Firstly, can an operating lease help my laboratory? Secondly, with all these changes, do operating leases still provide the same advantages? And, lastly, do they offer any new benefits under ASC 842?
The short and simple answer to all of these questions is yes.
An operating lease can help your lab in a number of ways, such as spreading the costs of equipment out over time and avoiding large down payments, effectively preserving working capital, extending your cash runway, and maintaining a positive cash flow (if you’re generating revenue at this point).
Despite the changes to the accounting treatment of an operating lease, it still offers the same tax benefits, allowing you to take advantage of potential tax deductions.
Operating leases can also help you keep your balance sheet clean in case you’re pursuing outside investments. Expenses are normal, and keeping track of them on your balance sheet, in addition to your income statement, will only provide great transparency to anyone interested in your financial statements.
Furthermore, with the new accounting treatment taking effect, it’s possible for your company to depreciate your leased assets and accrue interest expense on tax deductible operating expenses.
Simply put, operating leases help companies access the equipment they need without the burden of ownership and oftentimes with limited maintenance responsibilities, create the potential for tax deductions, and allow for a simple way to manage leased assets.
Our leasing program helps laboratories grow. Want to scale operations, throughput, and performance, but don’t have the cash on hand to acquire the equipment you need? Let us know.