Liquidation Value Versus Going-Concern Value

Working Capital and the Role it Plays in Your Business’ Success

Taking a Closer Look at Trial Balances

Contingent Liability Defined

Optimizing Your Business’ Performance with Capacity Management

Defining Materiality in Accounting

How the 2022 Consolidated Appropriations Act Impacted Accounting in 2023

Understanding Operating and Capital Leases

would resemble what’s otherwise considered a finance lease. When it comes to Canadian Accounting Standards for Private Enterprises (ASPE) and Generally Accepted Accounting Principles (GAAP), the terms capital lease and finance lease can be used interchangeably.

Operating Leases

Operating leases are used when the client wants to rent and not purchase. During and once the lease is up, the lessor is always in possession.

It can be cheaper to rent – and sometimes renting is the only option for small or medium-sized businesses that are unable to purchase assets. Another advantage for businesses is that they can stay competitive by being able to upgrade their assets since they don’t own it. Along with lessees generally only having to pay for asset maintenance costs, operating expenses for the leased assets are likely tax-deductible because they’re considered business costs. Agreements normally last three-quarters of an asset’s estimated economic life, and the present value of lease payments is usually less than 90 percent of an asset’s fair market value.

Finance (Capital) Leases

Once this agreement’s term is up, the lessee owns the formerly leased asset. Unlike an operating lease, it provides the lessee an opportunity to purchase the asset below fair market value through a bargain purchase option. It also differs in that the contract’s term spans a minimum of three-quarters of the asset’s estimated useful life. If the present value of the lease payments is at least 90 percent of the asset’s original cost, it qualifies as this type of loan.

Determining the Loan Type

Looking through the lens of IFRS, one way to decide what type of a lease to enter is to calculate the present value of the smallest lease financial obligations. Taking the following loan terms, we can determine what percentage of the minimum lease payments are of the asset’s fair value when the lease is signed. Here’s an example.

On the first day of the year, a business signed a lease agreement for five years for equipment that has a fair value of $150,000 and has an interest rate of 8.75 percent. A single installment of $33,750 will be paid at the start of each year. The equipment will be returned to the lessor at the end of the lease. The asset’s useful life is five years, with no residual value. The company chooses the straight-line depreciation method.

Since the equipment will be returned to the lessor, the bargain purchase option doesn’t apply. Also, since the economic life is five years and the lease term are the same length, it’s 100 percent, rendering the asset to have no alternative use once the lease is completed. Therefore, we can determine the present value as follows:

Number of Periods (NPER) = 5 annual payments over the loan’s life

Rate = 8.75 annual interest rate

FV = 0 (future value)

PMT = $33,750 (single payment per 12-month period)

Type 1 = (payment is made at the beginning of the year)

Calculated using Excel, the present value is $143,693. This present value divided by the initial cost means that the asset’s fair value when leased is 95.8% ($143,693/$150,000)

Based on this calculation, with the least lease payments’ net present value well above the 90 percent minimum threshold, it would be considered a finance or capital lease.

Understanding Mark-to-Market

Evaluating Net Operating Loss Considerations

Year one: High profits and big tax payments due

Year two: Net operating loss incurred

Year three: High profits and big tax payments due

The way a NOL deduction works in the example above is that the losses from year two can be used to offset taxes due in year three.

Net Operating Loss (NOL) = Taxable Income – Allowable Tax Deductions

Referring to the income statement, if the company’s bottom line is a net loss, then the company might be eligible to take advantage of the NOL deduction.

It’s important to keep in mind there have been modifications to what and how businesses may use this. Until recently, the IRS let businesses utilize the carryback method to offset losses to prior years’ tax bills (up to 24 months of tax liabilities), resulting in an immediate refund. However, with the passage of the Tax Cuts and Jobs Act, NOLs were modified. Effective Jan. 1, 2018, or later, the two-year carryback provision was removed (except for select farming losses), but allowed for an indefinite carryforward period. The TCJA also limits carryforwards to 80 percent of each subsequent year’s net income. Additionally, if a business records a net operating loss in more than one tax year, they must be exhausted in the order that the losses occurred. 

The Coronavirus Aid, Relief and Economic Security (CARES) Act permitted NOLs occurring in tax years 2018, 2019, and 2020 to be carried back five years and carried forward indefinitely. However, the exemptions have now expired. Losses that occurred in pre-2018 tax years are still subject to former tax rules, with any remaining losses expiring after 20 years. Beginning with the 2021 tax year, when the Tax Cuts and Jobs Act (TCJA) passed in 2017, it permitted carryforwards of NOLS indefinitely. However, only 80 percent of taxable income can be “carried forward” during a single tax period.

2021 and Forward NOL Example

Year one: NOL $10 million

Year two: Taxable income of $3 million

Year three: Taxable income of $5 million

For year two, with the taxable income’s carryover limit (80 percent) of $3 million is $2.4 million. With the carryover limit subtracted ($3 million – $2.4 million = $600,000), the company’s taxable income will be $600,000 for year two. The remaining NOL of $7.6 million will be considered a “deferred tax asset.” Looking at year three, 80 percent of the year’s $5 million in taxable income equals $4,000,000 in a carryover limit. Subtracting $4 million from $5 million in year three’s taxable income, the business will have $1 million in taxable income, and $3.6 million will be the remaining NOL balance at the end of year three. 

With the tax code continuing to evolve, businesses that stay up-to-date with changes in the IRS Code will make the most of their ability to maximize deductions and reduce liabilities.