Is your business short on money? In today’s day and age, entrepreneurs need a hefty amount of capital to keep the company operational. From purchasing equipment to financing working capital requirements, they need money at every step.
Often business owners seek help from their investors to raise funds through equity financing, but that might not be the best choice. After all, you are giving up a small share of your ownership.
If you are not ready to share your company with someone else, opt for debt financing. Here, you can raise money through bank loans at low-interest rates. Depending on why you need cash, you can also explore leasing options. Suppose you want to buy land, machinery, or non-current assets. Instead of getting a loan, consider leasing the asset.
Now, the question is how leasing works. It is pretty similar to a loan but has two options. You can choose an operating lease where you have to pay rent for using the asset. Likewise, a finance lease allows you to take control of the asset once the lease term ends.
But qualifying for a lease can be tricky because leasing an asset is more convenient. If you need help with this, have a look below.
Here we have highlighted five ways to ensure your company meets lease requirements.
1. Understand New Lease Accounting Standard
Even though accounting principles are consistent, standards are subject to new developments and adjustments. Lately, there have been a few changes in lease accounting standards which you must understand before applying for a lease.
Previously, accountants recorded leases based on international accounting standards (IAS) 16. Due to a few discrepancies and material elements, the board introduced International Financial Reporting Standard (IFRS) 16.
Besides changes in accounting treatment, it narrowed the lease to one category – finance lease for the lessor. However, it failed to account for public and private reporting GAAP, due to which ASC 842 came into play.
Even though this standard is implemented, ASC 842 effective date is subjective. Why? Because regulators want accountants to become familiar with the new standard before they can enforce its adaption in every organization.
Once you understand the changes in accounting standards, keep updating the financials. Likewise, identify the correct accounting treatment for leased assets. Is it an income statement adjustment or a balance sheet? Study the new standards in-depth to find answers to these questions and ensure your company is compliant.
2. Evaluate Financial Statements
When we talk about leasing an asset, there are two things – you wish to purchase the asset or use it temporarily. Either way, you must evaluate your financial statements to ensure lease adjustments won’t disrupt the finances.
Check if your income statement has rental scope if you don’t want assets’ control or ownership. That means calculating expenses as a percentage of sales. You have enough room for lease rentals if it is lower than 50%. If not, you might have to cut back on certain expenses to adjust rentals while ensuring it doesn’t affect profitability.
On the other hand, entrepreneurs who want to purchase the asset should check their balance sheet. If you already have non-current assets, consider disposing of them. Otherwise, an additional asset will overstate current assets, leading to an imbalance in the liability section.
3. Explore the Lease Scope
Undeniably, lease accounting has nitty gritty details because gathering all information in one place is challenging. Thus, you must begin by identifying your lease portfolio ahead of your actual lease application date. It will give you sufficient time to make determinations regarding accounting policy elections. Once the portfolio is ready, contact different departments to provide all lease-related documents. That also includes embedded lease clauses.
Next up, you must extract lease details and upload the information for every contract into accounting software. Further, determine if there are lease agreements that you can exclude. It will allow you to create transition and journal entries.
For instance, all the assets with a fair value of $5,000 are excluded under IFRS 16. The company must only account for immaterial agreements to comply with the accounting materiality concept.
4. Calculate the Rentals
Unlike interest, lease agreements require companies to pay rental charges. It is the cost of using the machine for a specified time. The longer you use the machine, the lower the rentals. Therefore, you must select an extensive tenure to get the best possible rental rates.
In addition, calculate rentals as a proportion of total expenses. You have to ensure these rentals don’t consume a significant chunk; otherwise, business operations might get affected.
Moreover, you can determine if you want to make monthly, quarterly, or yearly rental payments. Remember, this should align with your annual reporting period. Besides, study the terms and conditions related to rental expenses, such as whether the ownership gets transferred.
5. Work on Your Credit Score
Every company has a credit score that demonstrates its credibility to repay loans. Lenders give a lot of importance to this score before engaging in a lending/borrowing agreement. Companies with a good score land lease agreements at low rentals and interest rates, whereas organizations with poor scores fail to get approvals. But that doesn’t mean you can’t lease an asset; instead, focus on improving your credit score.
For starters, share the company’s information with regulatory bodies so they can validate all data on record. You can also collaborate with suppliers to have flexible payment terms and reduce liability overhead.
Likewise, ensure that your personal finances are stable and that you have a good credit score. Most importantly, don’t delay payments, reflecting positively on your report.
6. Conduct Due Diligence
Truthfully, accounting standards are rigid. If you fail to identify leases appropriately, perhaps, you mark operating leases for service contracts, which can make financials subject to materiality. Likewise, there could be consequences if companies don’t identify capital lease treatment. For instance, your profits can be subject to a miscalculation if you treat the capital lease as operating.
Therefore, every company must conduct thorough due diligence to eliminate any discrepancies in lease clauses. You must pay attention to detail and focus on the contract’s wording. A slight change in the clauses can change meanings, leading to failed lease approvals.
Leasing has become one of the most convenient ways of purchasing an asset. It doesn’t require entrepreneurs to make payment upfront; instead, they can pay for rentals monthly. That allows accounts to spread the assets’ cost over their useful life without charging depreciation.
If you wish to buy an asset on a lease, ensure you are well-acquainted with leasing technicalities. From documentation and scope to account standards, learn the ins and outs of the leasing world.