Tax Considerations of New Lease Accounting Rule ASC 842
November 26, 2019
This year, public companies were required to implement new lease accounting under the Financial Accounting Standards Board.
Previously, most leases were reported off balance sheet in financial statement footnotes. Now all leases, including operating leases, must be shown on the balance sheet.
The new rules, under ASC Topic 842, have had minimal impact thus far for public companies given the limited tax accounting details that are required in quarterly reporting. However, these same companies have to compute the impact of the new lease rules as part of their annual reports. The new rules require the recording of a right-of-use asset on the balance sheet, as well as a corresponding lease liability.
The new rules were originally slated to apply to non-public companies starting in 2020. However, the FASB recently approved a one-year reprieve for non-public companies.
While the FASB has issued the new standards, the income tax treatment of leases remains unchanged. The new rules therefore introduce book-to-tax differences and deferred tax implications that should not be left to the last minute to address. Here are additional considerations to ensure compliance.
1. Finance vs. Operating Leases
At the outset, it is important to assess lease type. For book and tax purposes, finance leases are treated the same, with interest and depreciation being reported separately. Due to the separate interest treatment of the lease liability, the expense profile is generally front-loaded.
Operating leases, however, require a straight-line expense profile, with interest and depreciation reported as a single-line item with the innocuous title of rent expense. The income statement is virtually unchanged by the new rules.
At this point, it is important to note that GAAP and tax lease classification rules are not identical and it is possible to have an operating lease for one and a finance lease for the other.
However, the balance sheet will see significant changes. As mentioned above, the balance sheet will now include a right-of-use asset and an associated lease liability. These accounts do not exist on a tax-basis balance sheet and therefore deferred tax assets and liabilities will have to be recorded and tracked.
2. Accounting and Tracking Impacts
The lease liability will be amortized similar to any other loan. For book purposes, the lease payments will represent principal and interest on the loan. The interest expense will be deducted as rent expense in the income statement. To make the rent expense whole, the right–of-use asset will be amortized to make up the difference in the income statement. Plain vanilla lease agreements will result in the depreciation on the right-to-use asset to be equal to the principal amortization each year. In these situations, the deferred tax assets and liabilities will move in unison.
While this may not sound that difficult, the rent expense will contain book elements that do not exist for tax. Practitioners should take care to separately identify the assets and liabilities and track the changes in such accounts with care.
3. State-Level Impacts
The new rule could also impact apportionment factors for determining state income tax. Many states still use the property factor in computing state income tax, so it’s important to review how this is affected by the new rule. For tax purposes, the rent expense is virtually unchanged. Considering the right-of-use asset and the rent expense in states that still use a three-factor formula approach will lead to inaccurate apportionment. States usually define quite well the property to be considered in the apportionment calculation and these rules should be consulted in light of the new rules.
The new standard will create new deferred tax assets and liabilities to track. These amounts should be calculated and documented. While the rules still identify operating and finance leases for GAAP purposes, they should not be thoughtlessly followed for tax classification purposes. This may be a good time to do such a review for tax purposes also.
In addition, state and local experts should be consulted to insure proper apportionment rules are used and to determine if there is any impact on the effective state tax rates.