Updated lease accounting rules that take effect in December promise to keep finance and accounting executives busy this year.
The new guidance from the Financial Accounting Standards Board requires that all leases with terms longer than 12 months be reported on a company’s balance sheet. Under the old standard, companies were only required to report “finance” or “capital” leases on their balance sheets, while “operational” leases were listed off-books in a company’s disclosures.
Under an operating lease, the lessor retains ownership after the lease term, as the lessee is renting the asset for a specific period of time. These leases are typically used for items like office equipment, real estate and, sometimes, trucks. A finance lease looks more like a loan where the asset is transferred to the lessee at the end of the term.
The old standard resulted in inconsistent reporting and made comparing balance sheets across companies difficult. A firm that leased trucks would appear to be in better financial shape than one that finances truck purchases because the operational leases were off the books. The company that financed its fleet would have the debt associated with those purchases listed as a liability.
The new rules — which are effective for fiscal years beginning after Dec. 15, 2018, for public companies and fiscal years beginning after Dec. 15, 2019, for nonpublic companies — have been in the works for about a decade, and most trucking executives believe they will improve transparency.
The ripple effect of the new rules on debt covenant agreements with financial institutions will be felt by fleets of all sizes, but the burden of implementing the new standards will arguably hit smaller companies and private carriers the hardest.
Those new burdens will be felt twofold; for one, companies more likely to lease trucks, equipment and other services rather than buying them will be affected. That includes smaller carriers, which tend to prefer leasing to buying trucks. Private carriers also will be disproportionately affected versus for-hire fleets, as roughly 70% of private fleets operate leased trucks.
While the new standards will not affect the operational benefits of leasing over buying — such as reducing upfront costs, providing predictable cash flows, and costly maintenance of aging vehicles — it will increase the administrative burden associated with documenting these leases. Which brings us to the second disadvantage smaller carriers face: fewer administrative resources and smaller accounting staff. The implementation burden will be greater for these companies, who may have to rely on third-party accounting service providers to assist their back office with the lease review and classification process.
Large trucking companies tend to be asset-based carriers with more sophisticated accounting operations, so data collection and reclassification of leases should be easier for them to manage.
While nonpublic entities have an additional year to comply with the new rules, their relative lack of resources compared to larger fleets could mean many are caught off guard when the deadline comes. Larger fleets with international operations or European ownership also have an added incentive for compliance since the new standards bring American accounting rules in line with those currently used in Europe.
Regardless of size, each company will be required to evaluate their books and undergo a due diligence process to comply with the standard. Fleets large and small must examine how the rules affect their debt-to-equity ratios as their loan agreements with a financial institution could be violated upon adoption. A company’s debt covenant with a bank typically includes a calculation stipulating how much debt the company can carry. If previously off-books operational leases are brought onto the balance sheet, a company’s debt ratio will increase. Despite the fact that a company may be in the exact same financial state as it was prior to implementation, the inclusion of operational lease expenses into the debt ratio could trigger a breach of their covenant, default and provide their bank with the legal authority to terminate the loan agreement.
While the FASB has stated that operating leases are not debt-like liabilities and therefore the new rules should not affect debt covenants with banks, lenders may still require carriers to renegotiate these agreements to provide a waiver or amendment to existing covenants. This is a concern for many CFOs as an estimated 70% of existing debt covenants will be in breach upon full implementation of the new standards. Financial institutions have an incentive to maintain a good working relationship with the businesses to which they provide loans, so it is unlikely that they will terminate loan agreements en masse; however, diligent financial professionals should protect their firms by discussing the implications of the new standard with their lenders before full implementation.
Everyone benefits from greater balance sheet transparency. However, the short-term pain of transitioning to the new standards will be great, particularly for those smaller firms that have delayed implementation.
Wieroniey manages ATA’s National Accounting and Finance Council, which engages in advocacy, education and research of tax, accounting and finance issues impacting the trucking industry. Prior to joining ATA, she worked in the financial services sector for Merrill Lynch and served as an attorney representing clients before the U.S. Tax Court.