Managing Equipment Leases with ASC 842 Software

I get asked this question a lot: “What are the key differences between accounting for real estate and equipment leases?” 

The answer from a technical accounting perspective: Nothing. But there are some areas to watch out for when accounting for equipment leases. 

First, let's discuss why equipment leases are important.

Sir David Tweedie, Chairman of the International Accounting Standards Board, famously said during the buildup to ASC 842 and IFRS 16 lease accounting standards, “One of my great ambitions before I die is to fly in an aircraft that is on an airline’s balance sheet.”

I think he was half joking but half serious. You see, before the new lease accounting rules, there were vastly different ways of accounting for financing the use of an asset. For example, if an airline bought an airplane and financed it with a loan, they would use the asset over time, make payments, and show assets and lease liabilities on their balance sheet.

If a competitor airline acquired an airplane and financed it with an operating lease, they would use the asset over time, make payments, and show no assets and liabilities on their balance sheet.

Tweedie was calling out the fact that while accountants strive for comparability, this was a glaring example of “apples to oranges” on the face of balance sheets. And the most famous example was not real estate - it was equipment!

The definition of a lease from ASC 842 compliance is “a contract, or part of a contract, that conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration.”

Equipment is right there in the definition of a lease, and while real estate makes up the largest dollar amount associated with the lease portfolio at the average company, equipment makes up the largest transactional volume.

Equipment leasing is a big deal. Now, let me tell you what to watch out for.

Evergreen leases

An evergreen lease, or more accurately, an evergreen clause contained in a lease basically states that the lease will continue indefinitely at the end of the stated term on a monthly basis. Sounds convenient, right?

Not so fast! I think evergreen clauses are at best convenient, but at worst they represent fraud.

Strong words? Let me explain. I’ve personally observed companies waste millions of dollars per year on equipment they don’t need because someone forgot to turn it in at the end of the lease. The lessee keeps paying the lessor while the equipment sits unused. 

It is a huge waste of money for the lessee.

So, if you choose to use evergreen clauses, make sure you have the latest ASC 842 lease accounting software to help guard against a perpetual waste of money through streamlined month-to-month notification and approval workflow.

Embedded leases

Embedded leases are leases contained within larger contracts, many times, service contracts. Many types of contracts contain the use of equipment. Here is a partial list:

Embedded leases can cause big problems at audit time, because it the external auditor finds a material one that the company didn’t account for, the financial statements may need to be restated. 

No accountant wants that! 

The best way to make sure that your auditor doesn’t find embedded leases that you missed is to think like an auditor. 

• Perform P&L analysis and sample contracts with recurring payments.
• Send surveys to departments that control contracts.
• Go on site visits, observe assets and ask questions!

Energy service agreements

ESAs or Energy Service Agreements are a hot topic right now. Here is the definition of an ESA from Energy.gov:

“Efficiency-as-a-service is a pay-for-performance, off-balance sheet financing solution that allows customers to implement energy and water efficiency projects with no upfront capital expenditure. The provider pays for project development, construction, and maintenance costs."

It continues, "Once a project is operational, the customer makes service payments that are based on actual energy savings or other equipment performance metrics, resulting in immediate reduced operating expenses. The energy services agreement (ESA) is the most common type of arrangement, but other models such as lumens-as-a-service and energy subscription agreements are also in use.”

The challenge that many lease accountants are running into is that despite ESAs being marketed as “off-balance sheet”, if a piece of equipment is involved, there is a good chance that an ESA contains an embedded lease.

Leasing is a great way to acquire equipment for business use. Just watch out for the “three Es” of equipment lease management: evergreen clauses, embedded leases and energy service agreements.