Changes in Lease Accounting Standards should not halt Digital Transformation
Co-authored with Vickie Wong, Assistant Corporate Controller, Cisco
Every so often, financial standards boards revise policies that affect all sectors and companies around the world to varying degrees. Such is the case with the recently issued accounting rules that require companies to alter financial reporting for lease agreements.
This update comes at an interesting time as we are in the midst of a new technological revolution. Companies of all types are beginning to embrace the age of digitization and transform the very framework in which they operate. The speed of technology change requires companies to analyze the way in which they purchase and finance their technology to manage their risks more effectively.
Financial reporting regulations can have a major impact on an organization’s decision-making process as they make their technology investments and executives become more informed about the reporting issues.
What you need to know
After some debate, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) agree that virtually all equipment leases need to appear on the balance sheet. While the two organizations do not align completely, both sets of new guidelines apply to all companies.
Under the new FASB guidelines, applicable for companies reporting under US accounting principles (US GAAP), equipment lease transactions historically categorized as either Capital or Operating Leases for lessees will be defined as Finance and Operating Leases. The IASB guidelines that many non-US companies follow no longer make any distinction between these two types of leases.
Operating Leases are at the heart of this project and the focal point of the new accounting guidelines as lessees are now required to reflect both the asset and liability associated with the value of the underlying equipment. Remember that overall, leases may still be favorable to loans or outright purchase for acquiring equipment. Customers with Operating Leases will find that the capitalized asset cost and associated liability may be lower than a comparable purchased asset and associated loan or cash purchase. In other words, although Operating Leases will add assets and liabilities to the balance sheet, the asset amounts (Right of Use amount) will likely be lower than the cost of an outright purchase.
“Leasing continues to offer many benefits for customers, including total solution financing, flexible terms and structures, cash flow and tax benefits and the management of obsolete or unused equipment,” says Kristine A. Snow, President of Cisco Capital.
What these changes mean for customers and partners
“Lessees or equipment purchasers might experience balance sheet recognition and ongoing administrative changes, but, the economic benefits [of leasing] remain the same,” said Vickie Wong, Assistant Corporate Controller of Cisco.
The lessee will recognize the “value” of the equipment as a Right of Use asset on the balance sheet and book an associated liability for the minimum lease payments. Right of Use being defined as the right to use equipment during the lease term. The Operating Lease liability will not be classified as debt but rather be an “other” liability. Finally, under US GAAP there should not be an impact on the income statement – allowing customers to focus on the structure, terms and value of the lease. For companies following international GAAP, Operating Lease expenses will no longer be recognized evenly over the lease term. This treatment may have an impact on the income statement. Under the new IASB rules, lease costs will be front-loaded.
Overall, while the administrative process for a lessee may change, requiring more involvement of their finance department, the benefits of leasing remain.
What you can do
There are options to help companies through this process. For example, captive finance organizations can help you explore how to optimize such changes by providing an immediate source of low-cost capital, flexible terms and structures along with payment plans aligned to cash flow needs. In addition, captive finance organizations can share risk with customers, providing total cost of ownership savings when deciding between leasing or buying.
To find out more about how the FASB changes might affect your business, please consider initiating conversations with the following parties:
- Bankers – Discuss the changes and possible impact on credit lines and covenants.
- Accountants – Seek guidance about their interpretations of the new guidelines.
- Technology partners/providers – Review purchasing and leasing options for your IT needs.
Each case is different but one thing is certain – technology is driving industries forward and a strong IT investment strategy is key to maintaining a competitive advantage.
*Cisco and Cisco Capital do not provide tax or accounting advice to customers. Tax and accounting treatment is the sole responsibility of the customer.