Lease accounting standards and their tax impact on financial institutions
It seems the newest lease accounting standards are finally upon us with the implementation of Accounting Standards Update on Topic 842, Leases (ASC 842), effective for fiscal periods beginning after December 15, 2021.
While the Financial Accounting Standards Board (FASB) originally set the implementation deadline for last year for nonpublic companies, it delayed it one year due to COVID-19. It appears it will not delay it again, and many financial institutions are beginning the implementation process.
These standards will not change how leases are treated for federal income tax purposes, since there was no corresponding tax law change related to ASC 842; however, there may be impacts to tax accounting for leases that financial institutions should consider during the implementation process.
GAAP treatment
So what are the changes for GAAP purposes? Virtually all leases must now be recorded on the balance sheet, whereas previously they might have shown up only on the income statement. There will still be a dual classification model where each lease is either an operating lease or a capital lease, now called a finance lease. The new lease standards require that lessees record right-of-use assets and corresponding lease liabilities for all operating leases greater than one year.
Capital lease accounting remains largely unchanged. On the balance sheet, the finance lease asset is typically recorded as part of property and equipment, and the lease liability is recorded as funded debt. From a profit and loss perspective, the lease asset is depreciated over the shorter of the lease term or the asset’s useful life, and interest expense is front-loaded as the lease obligation is amortized.
Operating lease tax treatment takes on an entirely new look under ASC 842. A right-of-use (ROU) asset and liability are recorded by calculating the present value of the lease payments using the appropriate discount rate. On the balance sheet, an ROU asset is classified as a long-term asset on a separate line item outside other property. The ROU lease obligation will also need to be separated into short-term and long-term liabilities.
On the income statement side, the profit and loss components of an ROU asset and corresponding liability are amortized under the straight-line method and presented together as rent or lease expense. Under ASC 842, neither amortization of the ROU obligation nor the ROU asset is considered interest expense or depreciation expense, leaving EBITDA unchanged from accounting for operating leases under the prior lease standards.
Tax treatment
For tax purposes, not much has changed. Leases will be treated as either a tax lease or a non-tax lease on the financial institution’s tax return.
Under a tax lease, the lessor maintains ownership of the asset and will take tax depreciation deductions (including bonus depreciation and Section 179) on their tax return. The lessee will report tax rent expense on their tax return.
A non-tax lease assumes that the risk and rewards of ownership are with the lessee; therefore, the tax deductions, such as depreciation and interest expense, are recorded by the lessee. The lessor will report interest income on their tax return.
Deferred tax accounting
While the tax treatment remains unchanged under ASC 842, financial institutions will need to consider the impact on their deferred tax accounting. For example, if you have a lease that would not be capitalized for income tax purposes, you will have zero tax basis in both the ROU asset and the related lease liability recorded for GAAP purposes. The difference between the GAAP basis and the tax basis will result in a temporary difference on your tax return and thus should appear on your deferred tax inventory. Financial institutions will need to recognize a deferred tax liability for the excess GAAP basis in the ROU asset and a deferred tax asset for the excess GAAP basis in the related lease liability.
The reversal of the temporary tax differences will be dependent on the GAAP classification of the lease. For capital leases, the new lease standard under ASC 842 will generally result in an accelerated expense recognition for financial statement purposes. For operating leases, the annual financial statement cost will generally be like current operating lease accounting. Finally, if any impairment is created for an ROU asset for book purposes, it will need to be reversed for tax purposes.
State tax considerations
This new accounting standard may have state tax implications as well.
First, some states levy franchise taxes on financial institutions based on the net worth of the business, so the franchise tax calculation may be affected.
In addition, many states continue to utilize a property factor for the purpose of calculating state apportionment. If an ROU asset is included with other owned property on the balance sheet, this may also affect apportionment percentages. Financial institutions will need to be careful to understand how a state defines property, which will likely require that the ROU asset be removed for purposes of calculating state apportionment factors.
How Wipfli can help
As your financial institution adopts the new lease accounting standards, consult with Wipfli to determine what the tax implications may be. Our knowledge and experience can be invaluable to you in this area as you implement ASC 842. Contact us to learn more.
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