Proposed changes to the lease accounting standards would change the way leases are categorized and could have a major impact on businesses operating with multiple leases.

Under current standards, when a business leases an item—whether a vehicle, copier, building or something else—it must perform a four-pronged test to determine whether the item is categorized as a capital lease or operating lease.

If it is determined to be a capital lease, the item must be recorded as both an asset and a liability on the balance sheet—the same as if you had bought the item and taken out a loan for it. If it is determined to be an operating lease, the business simply writes a check each month and records the expense. While it has to disclose in the notes the commitment to fund that item, it is not included on the balance sheet—a model that doesn’t always provide a faithful representation of leasing transactions.

If the proposed standard is approved—and I anticipate it will be—every lease will become a capital lease and must be recorded on the balance sheet.

This will immediately change the way businesses record leases, both new ones going forward and existing ones. Currently, the majority of leases for small businesses are operating leases, and turning those into capital leases will have both an accounting and financial impact. For example, many financial covenants surrounding bank loans are based on liquidity or debt-to-equity ratios, both of which could change dramatically under the proposed new standards.

Those businesses, especially smaller ones, that find themselves in this situation could suddenly have $1 million or more in previously unaccounted for operating leases on their books, creating a substantial change in the financial picture of the company even though nothing has materially changed.

The proposed update is expected to go into effect within the next year or two. To prepare for the proposed change, businesses should:

  • Evaluate their leases to determine what financial impact the change may have on the business.
  • Talk with their bank about the potential impact on their banking relationships upon implementation of new lease standards.
  • Take the proposed change into consideration going forward when determining whether to lease or buy equipment.

Until now, many businesses have preferred to lease, because the liability is not reported on their financial statements. But if it’s going to be presented there going forward, buying may be a preferable alternative to the benefits lost from previous leasing transactions.