Lease accounting rules were originally changed back in 2016, however many companies were not required to adopt the new accounting standards until 2021. That means that only recently will tax preparers begin to see changes on client financial statements as part of tax preparation.
While the lease accounting standards strictly affected GAAP and did not result in tax law changes, there are areas of the return that preparers will want to be aware of to address any potential changes.
Under new accounting rules, greater emphasis is put on leasing activity being captured on the balance sheet. The majority of the push for change in the accounting method was originally centered around the fact that previous lease accounting rules made it difficult to determine actual leasing activity as most of the recording was done off balance sheet.
Lessees must now report “right of use” assets on their balance sheet upon inception of a lease. The asset is offset by a lease liability calculated as the present value of the future lease payments and discounted using the implied lease rate.
With this change, preparers need to look for balance sheet changes that may need to be addressed as part of their business tax return filings. Because of the increased asset section, smaller filers who were potentially not filing a Schedule L on their returns prior to the accounting change may not exceed the $250,000 asset limit.
The change in rules will also potentially create a deferred tax situation which will need to be analyzed by preparers. Because lessees are not required to capitalize the right to use assets on the balance sheet for tax purposes, the lessee will have no tax basis in either the asset or the related liability.
The end result is taxable income upon the reversal of the right of use asset and related liability, resulting in a deferred tax liability for the excess basis under GAAP.
Similarly, any impairment of the right of use asset will need to be reversed for tax purposes.
State tax considerations also need to be reviewed. Certain states use an asset base to calculate franchise taxes. Changes to the asset base under new accounting rules could result in a change to franchise tax bills that clients are not expecting.
If your firm is not responsible for preparing the GAAP basis financial statements for your tax clients, it is highly recommended that you review the changes to client balance sheets with the accounting firm preparing the financial statements well in advance of preparing the return to avoid overlooking any potential changes.