Many of our clients have bank financing that requires certain covenants to be maintained. Some of these covenants restrict the amount of debt that can be put on the balance sheets (for example, a maximum debt to equity ratio). Operating leases are typically viewed as a possible solution, since assets can essentially be financed, but instead of having a big liability on the balance sheet, the lease payments are simply expensed as incurred. This practice is known as “off-balance sheet” financing.
Imagine the client’s displeasure, when during a review or an audit engagement, we ask for a copy of the lease agreement only to discover that the lease in fact meets the definition of a capital lease, essentially requiring that the liability is set up on the balance sheet to be equal to the present value of the future minimum lease payments. This makes the client’s attempt at “off-balance sheet” financing completely unsuccessful, potentially leading to covenant violations.
Many leasing companies understand accounting criteria for treating leases as capital (where the value of the asset and the corresponding liability are recorded on the balance sheet) or operating (when lease payments are expensed) and try structuring their products in a way that allows to achieve the desired accounting outcome. Don’t be afraid to ask your representative at the leasing company whether the terms of the lease offered to you would make it capital or operating for accounting. Please note that this blog focuses on ASPE rules, as majority of our audit and review clients report under ASPE. If your company reports under IFRS, leasing rules there are changing, making “off-balance sheet” financing even more difficult. Don’t be afraid to contact us to discuss the new IFRS Leasing rules.
Here is the synopsis of the ASPE rules around leases. We hope they help you better navigate through the various products offered by leasing companies. Keep in mind that if your goal is to achieve “off-balance sheet” financing, you are trying to avoid getting yourself into a capital lease scenario.
Section 3065 “Leases” defines a capital lease as “a lease that, from the point of view of the lessee, transfers substantially all the benefits and risks incident to ownership of property to the lessee.” The Section provides 3 criteria which help determine whether the risks and benefits of ownership in fact transfer. If at least one criterion is met, the lease should be treated for accounting as a capital lease.
In plain English, the 3 criteria are:
- There is reasonable assurance that you will obtain ownership of the asset at the end of the lease. This is usually evident from specific clauses in the agreement stipulating that the ownership will transfer to the lessee (you) at the end of the lease. Alternatively, this criterion is also met when there is a bargain purchase option (BPO) at the end of the lease. The key word here is “bargain”- it has to be below what the value of the asset would be at the end of the lease. BPOs are usually pretty evident as they are set at a nominal amount ($10 for example). The logic is that if you have the option to buy the asset at $10 at the end of the lease, you will certainly exercise that option, which creates reasonable assurance that ownership will in fact transfer at the end of the lease.
- The term of the lease covers 75% or more of the asset’s useful life. This criterion addresses the notion that if you use an asset for the majority of its life and get the majority of the economic benefits offered by the asset, it is equivalent to owning the asset, and therefore, the asset would be treated as capital.
- The present value of lease payments at inception of the lease is 90% or more of the fair value of the leased asset. The calculations involved could get tricky because the discount rate used to calculate the present value may not always be easily available. Figuring out the fair market value of the asset could also have challenges. The logic behind this rule is that if you are going to pay for the full value of the asset over the lease term, it is equivalent to owning it, making it a capital lease.
The rules seem quite simple and founded on common sense. The trick is being aware of the rules and having a thorough understanding of the lease agreement you are about to sign. The terms that trigger the capital lease treatment are usually in small print and may be worded in a way that is tricky. If “off-balance sheet” financing is important to your company and you are considering leases as an option, don’t hesitate to contact us for help in deciphering the terms of your lease.