The new lease accounting standard, ASC 842, was issued by the FASB in early 2016. Many public companies have already adopted the standard with private companies soon to follow. However, adoption or initial compliance with ASC 842 is just the first step. There are many other considerations that companies must plan for in “Day 2” and beyond. One such consideration is how federal income taxes and related financial reporting will be impacted.
ASC 842 was issued to address concerns around “off balance sheet financing” associated with operating leases. The major change associated with ASC 842 is the addition of right of use (ROU) assets and lease liabilities to the balance sheet for operating leases. Tax accounting for leases hasn’t changed, but the introduction of ROU assets and lease liabilities to the balance sheet changes the tax accounting process.
For tax purposes a lease can be classified as a true lease or as a sale (financing). Tests are involved to determine which party carries the benefits and burdens of ownership. The tests for tax treatment are largely based on case law, depend on the substance of the transaction, and are similar but not identical to the finance vs operating tests in ASC 842. Ultimately, for the lessee, the tests determine when and how expenses become deductible for tax purposes. Because the classifications can differ from financial reporting requirements, book-tax differences usually result.
Classification determinations can certainly put GAAP books and tax books out of sync, but other items can also generate book-tax differences. For example: Tenant Improvement Allowances (TIA) received up front are recorded as an offset to the ROU Asset under ASC 842, which, for an operating lease, has the effect of reducing the level rent expense over the term of the lease. However for tax, TIA’s need to undergo a further test regarding which party owns and funds the improvement. Then, a determination can be made regarding the impact to the lessee’s income and deductible expenses, which may or may not correspond to the book treatment under ASC 842. Other items that may generate differences include: impairment scenarios, free rent periods, direct costs, asset retirement obligations, and embedded leases.
Deferred tax assets and liabilities
ROU asset and lease liability accounts are being added to the balance sheet for the first time for book purposes. The book and tax basis for the associated leases will need to be tracked going forward to calculate and record resulting deferred tax assets and liabilities.
Companies should involve tax resources early in the process of planning for lease accounting compliance. Ask your lease accounting software provider to explain how clients have addressed tax implications. Partner with a lease accounting software provider that offers reporting features, experience and expert advice.