New FASB Code May Negatively Impact Business Taxes
- Posted on: Mar 13 2020
The Financial Account Standards Board (FASB) has replaced the Accounting Standards Codification (ASC) regarding property leases. The new standard, referred to as ASC 842 or ASU 2016-02, replaces the 40-year-old US GAAP leasing standard, often referred to as ASC 840.
ASC 842 was issued in February 2016 to help dis-incentivize businesses from leasing property rather than purchasing it. In the past businesses have often leveraged their leases as a business expense to help make their balance sheets look better. This has been a common tactic when it comes to obtaining business loans. However, the new standard changes things.
The New Code
Whereas there has always been capital (finance) leases and operating leases, ASC 40 only required businesses to capitalize finance leases on the balance sheet, with operating leases usually listed as a footnote in their financial statements. However, under ASC 842, most leases – including operating leases – are to be capitalized on the balance sheet.
Like most law though, there are some exemptions. Short-term leases (those no more than 12 months in length) may legally be exempt. At the commencement of each lease, lessors (those leasing out the property) must classify the lease based upon the criteria listed in the code. Classifications of leases include:
- Sales-type lease;
- Direct financing lease; or
- Operating lease.
ASC 842 will not change the classification of most leases, nor will it change the way in which cash flow and expenses are recognized (based on the classification of the lease as either finance or operating.
Businesses are required to decipher whether a contract includes a lease when it is signed. ASC 842 provides new guidance.
A contract is considered a lease if it gives the lessee the right to control the use of the property for a period of time when money/consideration has been exchanged.
Control exists when two requirements are met:
- The business has the “right to obtain substantially all of the economic benefits from use of an asset;” and
- The business has the “right to direct the use of that asset.”
Under the US GAAP standard, the lessee has only been obliged to meet the first requirement; under ASC 842, the second requirement must be determined by the business.
How Will ASC 842 Impact Businesses?
Under ASC 842 renters must claim their entire lease as a liability based on the present value of the lease’s future payments. This number is determined based on the implicit rate stated in the lease or the borrowing rate of the business renting.
Since renters will not have an asset to cover their lease, the ratio on the balance sheet of business lenders will be greatly skewed, which will make it much more difficult to obtain necessary loans. Ultimately both assets and liabilities will increase. This means that right-of-use assets will be recorded on the balance sheet as will the corresponding liability of the lease.
Under an operating lease the lessee (the borrower) must identify the expense of the lease on a straight-line basis over the length of the lease. But under a finance lease, the lessee must identify both the interest expense as well as the amortization expense.
On December 15, 2018, public companies started to implement the new standard; private companies will do the same on December 15, 2020. The new standard is expected to bring in $3 trillion of lease liability and hopes to align the lessor model with the principles in the FASB’s new revenue recognition standard, ASC 606.
The Law Offices of Brian L. Fox, APLC Helps Businesses with Tax Laws in California
Tax laws can prove quite complex and confusing for many. An easy misunderstanding could lead to consequences, which could negatively impact your business. That’s why it is so important to consult with a knowledgeable and experienced California Business Law Attorney.
At the Law Offices of Brian L. Fox, APLC, we will ensure that your business remains compliant at all times and work with you to make the right decisions. To learn more about tax law or to schedule a free consultation, contact us today!
Posted in: Business Law