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New rules will impact the lease/buy decision
Practices may soon be required to add leases to their balance sheets as liabilities.
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Even as credit becomes more readily available, whether to buy or lease is a question facing many optometric professionals. While there is no one correct answer that fits every situation, nor every optometry practice, compared to the simplicity of buying, leasing is far more complicated and may be getting more complex.
Thanks to negotiations between the International Accounting Standards Board, which sets rules for many countries around the globe, and the U.S. Financial Accounting Standards Board (FASB), which writes the rules in the U.S., the lease accounting rules as we currently know them are changing. The new rules will soon require many practices and businesses to add all but the shortest leases to their balance sheets as liabilities, much like debt, affecting the way potential lenders, investors and suppliers view the practice.
New rules
Today, few leases get recorded because the guidelines allow lease contracts to be structured to appear as simple rentals. If an obligation is not recorded on a balance sheet, it makes a practice appear less leveraged than it really is.
The existing guidance under the Generally Accepted Accounting Principles (GAAP) says optometrists are required to record lease obligations on their balance sheets only when the arrangements are comparable to financing transactions, such as rent-to-own contracts for buildings or vehicles.
According to the Accounting Standards Update No. 2016-02, Leases (Topic 842), practices that lease assets will now be required to recognize assets and liabilities on their balance sheets when the lease term is more than 12 months. Previously, the recognition, measurement and presentation of expenses and cash flows arising from a lease primarily depended on its classification as a finance (capital) lease or operating lease. But unlike current GAAP in the U.S., which requires only capital leases to be recognized on the balance sheet, the new standard requires businesses to include both types of leases on their books.
Obviously, this is a huge change from current practice requiring lessees to record a large asset and a large liability on their balance sheet. Practices and businesses will no longer be able to structure lease agreements to achieve off balance sheet reporting and will, in many cases, have to monitor the effect of this change on their debt-to-capital ratio and related debt covenants, among other things.
The new guidance is not expected to prevent any optometrist from acquiring the equipment and assets necessary to grow their practice. In fact, there are many reasons to lease equipment, and the primary factors will remain intact under the new rules — from maintaining cash flow, to preserving capital, to obtaining flexible financial solutions, to avoiding obsolescence.
On the other end of the leasing transaction, lessor accounting will remain largely unchanged. The vast majority of operating leases should, for example, remain classified as operating leases, and lessors should continue to recognize lease income for those leases on a generally straight-line basis over the lease term, according to the FASB.
Why lease?
Equipment leasing is similar to a loan in which the lender buys and owns equipment and then “rents” it to an optometric practice at a flat monthly rate for a specified number of months. Although lease financing is generally more expensive than bank financing, in most instances it is more easily obtained.
Among the reasons given by optometric professionals for leasing are the ability to have the latest equipment, consistent expenses for budgeting purposes, help in managing practice growth and no down payment.
Leasing offers real advantages, including reduced cash outflows and greater control. See a short list of leasing advantages in the accompanying table.
The nuts and bolts
In addition to making balance sheets larger, the new guidelines will change income statements for many optometric practices.
Currently, a practice that leases equipment for $1,000 a year for 5 years would show a $1,000 expense each year. Under the new guidelines, that practice would show a larger expense in early years and a smaller one in later years. That is because the accounting would be similar to a situation where the business had borrowed money to purchase the asset, paying off the loan in equal payments over 5 years. In early years, the interest expense would be higher than in later ones.
Another significant change will mean that most real estate leases will be accounted for differently. While they, too, would go on the lessee’s balance sheet, the value would be based on the expected lease payments over the life of the lease. The lessee would, fortunately, not have to assume that it would exercise renewal options — unless those options were so favorable as to clearly give it a financial incentive to renew.
In cases where the lease payment is based on something that will vary — like a store lease where the lessee pays a fixed rate plus a percentage of income — the value would not have to reflect the expected additional payments. That would keep the asset value and related debt lower than it might otherwise be.
If, however, the rent would vary based on an index — like the Consumer Price Index — the initial value would be based on the current level of the index. The values of the asset and liability would be updated every year as the index changed.
The silver lining
The new lease accounting guidelines, like the FASB’s slightly older set of rules on recognizing income, also offers a treat for many small practices, albeit a somewhat hidden and hard-earned one. Admittedly, they will require a detailed collecting and spread-sheeting of existing leases held by the optometric practice. Fortunately, such an accounting will allow a serious study of how well all of those leases fit into the practice’s business model.
Should the practice continue on its past course with automatic “as is” lease renewals? After all, while much focus is on the cost of compliance, there are also ways to identify cost savings by examining the leasing activities of the optometric practice. Another question is whether the existing insurance contracts that generate revenue are still right for the practice now that new guidelines exist for when revenue must be recognized.
Implementation now, mandatory later
Publicly traded companies will be required to adopt the new standard for fiscal years beginning after Dec. 15, 2018. For calendar year-end public companies, this means an adoption date of Jan. 1, 2019, and retroactive application to previously issued annual and interim financial statements for 2017 and 2018.
Nonpublic companies, including privately owned businesses and professional practices, will be required to apply the new leasing standard for fiscal years beginning after Dec. 15, 2019. Thus, for most optometric practices this means an adoption date of Jan. 1, 2020, and retroactive application to previously issued annual financial statements for 2018 and 2019. No one will object if a practice jumps the gun in applying the new guidelines.
Although these effective dates might seem like they are quite far away, every optometrist should begin preparing now. After all, with many practices involved with any number of leases — and lessors — the long adoption period can mean fewer surprises with existing leases.
To lease or buy
Should your optometric practice lease or buy equipment? Leasing equipment and other business property can be a good option for a practice with limited capital or in need of equipment that must be upgraded every few years. Purchasing equipment can be a better option for established practices and businesses or for equipment that has a long usable life.
Although taxes play a role in whether to lease or to purchase, they should not be the deciding factor. But will the new accounting guidelines’ impact on the practice’s financial status come as a surprise? Most importantly, when should your optometric practice begin playing under the new rules? That is a question best answered by a knowledgeable professional, one who can also provide help in phasing in these new leasing guidelines.
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- Mark E. Battersby has been reporting on news and developments in the tax and financial arenas for more than 25 years. He can be reached at MEBatt12@Earthlink.net.
Disclosure: Battersby reports no relevant financial disclosures.