Why You Don’t Want to Violate This Operating Lease Regulation

Posted by Matt Walden on 10 31, 2022



Every year, new tweaks are released into the corporate accounting spectrum. Usually, these tweaks have very little impact on the company's bottom line. It might affect how a company files taxes or what cell of a spreadsheet certain data is put into, but for the most part, these changes don't carry much of an impact.  
However, this 2021 law around operating leases and capital leases made an important exception. In fact, you'll regret not taking advantage of this accounting rule if you fail to implement it into your business practice. 

Operating Lease vs. Capital Lease? 

The new  accounting  rule changes how businesses can treat operating lease commitments. As of right now, a business can place leased assets into one of two different categories: an operating lease or a capital lease. 


Capital Leases 

A capital lease is placed on a balance sheet in the form of a liability that funds the company assets — for example, a loan on a vehicle. The money is paid on a regular basis until the vehicle is purchased, which then gives the owner outright ownership of it (and removes the bank lean on the vehicle). 


Operating Leases 

An operating lease is different from a capital lease in that it is not placed on a balance sheet. In fact, there is no official transfer of ownership with an operating lease. It's like leasing a rental property. You can go on paying indefinitely on the lease, but there is never any ownership transfer. You continue to pay until the lease is up, and either continue on with the lease or move elsewhere. 
This makes it difficult for some businesses, where a company does not own a product it produces. An airline, for example, will pay an operating lease on the airframe (the body of the airplane). The airframe is produced by a manufacturer, such as Boeing, Airbus or Gulfstream. The airline will then select the desired engine to install on the airplane (the airframe manufacturer typically does not manufacturer the engine as well, it is instead produced by a company such as GE. The airline, who contracts with the airframe manufacturer, selects an engine type and the airframe manufacturer then attaches it for the airline).  
Due to the varying pieces from different manufacturers installed on an airplane, the entire plane is almost never on an airline's balance sheet, because part of the plane is on an operating lease. There might be a capital lease on the airframe, but an operating lease on the engines. This makes it difficult for the company to track certain expenses as it splits elements of the same final product into two different kinds of leases. 
With these upcoming  accountant rule changes though, an operating lease will move to a balance sheet, representing a form of ownership by the company paying on the lease. 

How Does This Change Impact a Business? 

The major impact on businesses is those holding a number of operating leases. Previously, an operating lease, as it did not go down as an actually owned asset by the company, did not allow the business to claim it as a tax-deductible expense. After all, the business did not own it (or have the ability to claim it), which simply meant the company paid on the operating lease and nothing more came of it. 
Now, the change allows a company to place the operating lease in the books. This causes both benefits for some businesses and expenses for others, depending on how the operating lease is categorized for a given company. 
Property owners that lease units to companies will see the biggest return on this accounting change, although other businesses that lease out equipment will likely see a substantial improvement as well (such as telecom companies and industrial manufacturing plants). However, on the flip side of the spectrum, for companies that rent buildings/equipment instead of owning them, the business must now account for these leases (such as the property the business rents out). This suddenly becomes an added expense for such a business. 

Designed To Hurt or Help Companies? 

This accounting change isn't designed to hurt one kind of business or help another. It's designed to close an accounting loophole that has allowed some businesses to thrive without claiming certain profits or expenses. A McDonald's, for example, generally owns the property and all the equipment used within the production. This increases the up-front expense of opening a business, but it allows the company to write off many of the purchases as a business expense. These changes will likely not alter the tax filing and bottom line of such a business. 
However, Chipotle, another "fast food" type of restaurant, almost never owned the property. Instead, most Chipotle restaurants rent properties and sign operating leases. As the lease will suddenly be placed onto the books of a Chipotle ledger, it represents an area of the business the company will now need to pay taxes on that it didn't previously. This isn't designed to hurt a company like Chipotle, though.  


Companies such as Chipotle, and several mall-based stores (like Foot Locker, The Gap, Ulta Beauty, and others) have used the operating leases as ways to inflate the appearance of sales numbers without paying proper taxes on it. These changes are designed to correct it. 

Potential Impact 

Some businesses that will feel the burden of these changes may begin to collect owed debts to prevent a substantial hit to the company's bottom line. Those effects might cause a handful of minor problems, although this is where having loan clauses built into any lease is critical, as these leases need to be designed not only for the current market but for potential changes in the market. 

The Bottom Line 

The 2021 accounting rule is designed to shore up some accounting loopholes businesses have been taking advantage of for years. It isn't designed to hurt or help one form of business over another. It's instead designed to level the playing field and make sure all companies pay the correct amount of taxes without ballooning profit numbers due to the high percentage of operating leases. ICS wants your business and all other companies to understand these changes and to make the necessary arrangements as new rules  go into effect. 

Contact ICS today to find talent that can help you further understand these changes and implement them. We have plenty of talented professionals waiting to assist your company.  


<< Previous Post Next Post >>