Professor Elam

Wed Nov 11, 2015

Here is a rundown on the new rules for long term leases which will take effect in 2018.

There is a distinction between an operating lease, for example, you rent an apartment for a year, and a capital lease. Capital leases extend beyond a year and include major pieces of our economy including rail cars, passenger jets, and Walgreens and CVS drugstores. 

Leases have been subject to four capital lease tests. If the lease falls under any one of the four, it is deemed a capital lease. This means it has to go on the balance sheet as long term debt.This of course adversely affects a firm's debt/equity ratio. And so, firms seek to 'serpentine' among the rules trying to create an operating lease rather than a capital lease. 

My understanding of the new rules is simple. If the lease extends beyond one year, it has to go on the balance sheet. 

This will have a tremendous effect on firms that are simply just a lease like airlines, rails, and drugstores. Between the new lease and revenue recognition rules, the accounting times they are a changin', to paraphrase Bob Dylan.