Lease Accounting Rules, Small Business Financing and the Cloud
There are changes in lease accounting rules that may have broader implications than expected. Lease accounting, or accounting in general, isn’t exactly an exciting topic and generally doesn’t come up in conversation. But the changes to how business equipment and other leases are accounted for and reported could become additional fuel for cloud adoption by businesses – small business looking for financing, in particular (= lots).
First, what does accounting for leases have to do with small business financing? Quite a bit, actually. The balance sheet is one of the things a lender will look at when considering a small business for a loan, and if lease obligations and leased assets are on the balance sheet, they’re going to want to talk about them. They’ll also possibly look at asset turnover – trying to understand exactly how much in assets it takes for the business to make “x” amount of money. Banks and other lenders like to know they’re loaning money to a business that is going to pay it back, and in a reasonable amount of time. They will limit their risk potential as much as possible, and they do it by looking through the financials and related information.
Business value is generating sustainable cash flow. If you run a highly efficient business, the more top-line growth you deliver, the more cash flow you enjoy. For capital-intensive businesses (either through the need for capital equipment or working capital), growth can actually lower your cash flow and diminish your business value. To understand which side of the equation your business resides, accounting professionals will often look at the return on total assets calculated over time, dividing the operating income for each period from the P&L by the appropriate period values of total assets from the balance sheet. The resulting metric describes how efficiently assets are applied to creating earnings.
This can be a difficult conversation with the banker for new businesses, as they have little to go on in terms of historic data to show the bank. The P&L (profit & loss, or Income Statement) only reflects current business performance, not what it can do in a few months or years. By putting leases on the balance sheet, businesses are now reflecting a more realistic view of things, but are also introducing additional items for scrutiny and question by the lender; things which are often described more in terms of business strategy than in proveable numbers. That makes getting the loan just that much tougher.
Previous rules relating to business leases didn’t necessarily require that the business recognize operating leases (leased items and lease obligations) as assets and liabilities on the balance sheet. This is among the reasons why businesses lease equipment – they are able to obtain the item without having to record a single large capital expenditure.
The FASB changes demand that accounting for leases should be standardized, forcing the lesees to report all leases on the balance sheet, reflecting both the benefit (asset) and the cost (liability) associated with the lease. Stated in a press release on the subject: “The new guidance responds to requests from investors and other financial statement users for a more faithful representation of an organization’s leasing activities,” stated FASB Chair Russell G. Golden. “It ends what the U.S. Securities and Exchange Commission and other stakeholders have identified as one of the largest forms of off-balance sheet accounting, while requiring more disclosures related to leasing transactions.”
“a capital lease creates a tangible right where you own the equipment; the liability in a capital lease is true debt…”
By understanding how these changes in accounting for leases impact businesses, cloud solutions providers now have an additional lever to use with prospective customers: leasing equipment isn’t necessarily the way to keep capex off the balance sheet any longer.
One of the big value propositions offered by many cloud solution providers is that their service is paid for as a monthly business expense rather than a large up-front capital expenditure and investment. Businesses are able to use the solution and benefit from it without actually “buying” anything, it’s just subscribed instead. All of this is really a fancy way of saying “renting but not owning”, but the result to financial reporting is the same: it’s not on the balance sheet, it’s on the P&L in chewy chunks. This used to be a preferred treatment for leases, too, allowing businesses to reflect the usage and payment in little parts rather than a big one. It was “gentler” on the balance sheet. But leasing equipment and software for on-premises use won’t be competing with the cloud and subscription service any longer, closing off the “impact to the balance sheet” conversation entirely and making cloud IT just that much more important to small businesses who need cash to fuel business growth.