Pub. 7 2017 Issue 1

18 AUTOMOBILE DEALER NEWS ILLINOIS www.illinoisdealers.com Why does the update matter? Under the current rules, dealerships can structure their lease obligations as operating leases instead of capital leases so that they do not have to be listed on a balance sheet. The operating leases are included in the footnote section of financial statements, where the terms of the lease are itemized. Payments for operating leases are listed as rent. What’s the advantage to putting lease information in footnotes instead of on balance sheets? You can borrow money more easily because the entire approach gives the appearance of more favorable ratios and a healthier-looking bottom line than is actually the case. This less-than-transparent approach favors entities that want to understate the effect of leases on assets and liabilities, but it does not benefit anyone who wants to have a more accurate understanding of how an entity’s leases affect its financial well-being. As a result of the update, however, dealerships will now be required to list these lease assets and liabilities on balance sheets when the lease is for more than one year. The change affects equipment, real estate, vehicles, and other assets. The update will also affect the monthly financial statements for manufacturers because manufacturers comply with U.S. Generally Accepted Accounting Principles (GAAP) within their accounting manuals. What will the change in accounting standards mean for your dealership? It will affect financial ratios and performance metrics, and it will probably affect compliance with debt covenants. ASC Topic 842 changes the definition of the term “lease” by making it broader than the current definition, which is in ASC Topic 840. In order for a contract to be defined as a lease, there are two conditions: • The customer gains control of the asset for a specific period of time in exchange for some formof consideration, such as cash. The key word here is “control.” If you take all the output from a specific output but you don’t have control, then no lease exists. When a lease does exist, however, it should be reflected on the balance sheet because both an asset and a liability have been created. • The use of the asset has to be specified, either explicitly or implicitly. The asset can be equipment, property, or a plant. Assets can also be large or small. Data management systems, fleets of cars, and real estate will count, but so will smaller items such as copy machines. Under the current rules, dealerships did not really have to think about whether a contract qualified as a capital lease or an operating lease. That is going to change. • The term “capital lease” is essentially being replaced by the term “finance lease.” Most capital leases will now be defined as finance leases. • Finance leases and operating leases will both be on the balance sheet. • Categorization of the lease will matter. Although categorization won’t affect the impact of the total cash flow, it will determine the following: o Operating leases will be 100 percent classified as operating cash flows. The cost will be amortized on what is essentially a straight-line basis over the lease term and will be listed as part of operating activities. o Finance leases will be divided. One part will be classified as financing and part will be classified as operating activity. Right-to-use assets will be amortized separately from the interest on the lease liabilit y. Repayments on the lease liability’s principal will be listed as financing activities. Interest payments, for lease liability and also variable lease payments, will be listed as part of operating activities. o When looking at the earlier years of a lease, the expenses will be higher than they would have been under the current rules. The fact that expenses will go up is important because those increased expenses are used to calculate some of the dealership’s key financial ratios. More specifically, finance leases will usually have a higher EBITDA (earnings before interest, tax, depreciation, and amortization) than operating leases will have. n Accounting Standards — continued from page 16 In other words, you will need information from 2017 and 2018 when you are preparing financial statements for 2019 so that any leases you have right now, or that you enter into, can be shown on your balance sheet after the guidelines go into effect.