New Lease Accounting Standard Is Fast Approaching
By Christopher Jackson, Partner, Assurance Services
Over the years, I have seen several instances where companies have pushed the envelope in structuring leases to keep liabilities for leased assets off the books by classifying them as operating leases rather than capital leases. A capital lease requires the lessee to record the leased asset, along with a liability representing the present value of future lease payments, on the balance sheet, whereas operating leases are regarded as off-balance sheet financing.
One extreme example of such an attempt to keep a lease off the books involved a lessee who treated a three-year lease for a major HVAC (heating, ventilation, and air conditioning) system embedded in the building infrastructure as an operating lease. The vendor that installed the HVAC system attempted to develop creative leasing terms with the intention of preventing the lessee from recording the HVAC system lease as a liability. There was no intention or practical manner to remove the HVAC system from the building after the three-year lease period ended, and the HVAC system will last for many years beyond the three-year lease period. Even though the vendor portrayed this as an operating lease to the company that acquired the HVAC system and labeled the actual lease as an “Operating Lease Agreement,” in essence it was a capital lease.
When Financial Accounting Standards Board Accounting Standards Update 2016-02 (ASU 2016-02), Leases, becomes effective, there will no longer be opportunities to structure such leasing agreements as operating leases in an effort to keep them off the balance sheet.
Under ASU 2016-02, a right to use asset and a corresponding liability will be recorded on the balance sheet for practically all leases with initial terms longer than 12 months, with very limited exceptions. There are provisions to include leases that are 12 months or less in duration, where it is reasonably certain that the leases will be extended. Therefore, if companies structure leases as short-term in an effort to circumvent the provisions of ASU 2016-02, they will still be required to record the leases on the balance sheet. Preexisting operating leases that still exist when ASU 2016-02 is first adopted will also be recorded on the balance sheet when the leasing standard is adopted.
The new standard is effective for fiscal years, and interim periods within such fiscal years, beginning after December 15, 2018, for public entities and for fiscal years and interim periods beginning after December 15, 2019, for non-public entities. Early adoption is permitted.
Not-for-profit entities with conduit debt obligations should consult the requirements of ASU No. 2013-12, Definition of a Public Business Entity, and the AICPA Series of Technical Questions and Answers codified in Q & A Sections 7100.01-7100.16 for further clarification regarding whether they meet the definition of a public entity.
In July 2018, the FASB issued additional transition options in ASU No. 2018-11, Targeted Improvements to Topic 842, which eliminated the original requirements of ASU 2016-02 to restate all comparative periods and to now allow for a cumulative catch up approach. Under ASU 2018-11, companies can now elect to record the cumulative effect of adjustment in retained earnings at the beginning of the period when the new lease rules are first adopted, rather than restating all periods presented in the financial statements.
In order to facilitate the transition to the new leasing accounting standard, companies should take the following action steps:
- Obtain an accurate comprehensive inventory of all operating leases that are currently off balance sheet, but will need to be recorded when ASU 2016-02 is first adopted.
- Determine the impact of ASU 2016-02 on the company’s financial statements, including the expanded disclosure requirements.
- Analyze debt covenant calculations in order to have them modified by the lenders to address any negative impact resulting from ASU 2016-02. Some examples of financial ratios that will be impacted include the following:
- Current ratio will decrease.
- Debt-to-equity ratio will increase.
- Return on assets will decrease.
- Determine whether loan agreements will require other modifications regarding lender limits on the amount of capital asset additions or restrictions on capital lease agreements.
- Consider the impact on earnings before interest, taxes, depreciation and amortization (EBITDA). Since rent expense will now be included with interest expense and depreciation expense, EBITDA will improve. This could have an impact on employment agreements with bonuses linked to EBITDA and certain business combinations with earn-out arrangements linked to EBITDA.
- Consider the tax implications, in particular as relates to the creation of timing differences that will give rise to deferred tax assets and liabilities.
- Enter into leasing agreements that are the most beneficial from an operational standpoint rather than to qualify for off-balance sheet financing.
I have experienced many instances where companies entered into leases that had unfavorable business terms and consequences just to keep the liability off the books. I have always been a proponent of not letting the accounting treatment dictate operational decisions. There will be no long-term financial reporting benefit to entering into leases today that meet the criteria for classification as operating leases, as the liabilities will ultimately be recorded on the balance sheet when ASU 2016-02 is adopted.
Companies should enter into the best lease for operational reasons, rather than enter into a short-term lease or to avoid renewal options in an effort to minimize the liability. Short-term leases could have negative operational consequences, such as higher rent amounts, volatility of rent increases by not locking into lower multi-year rates, the level of effort and aggravation to negotiate leases more frequently, and fewer opportunities to negotiate landlord-paid tenant improvements. Some lessors might be motivated to offer better terms on longer-term leases to encourage lessees to enter into longer leases. Companies should consider taking advantage of these better lease terms if they benefit the company, regardless of whether they increase liabilities. Most lenders should understand the impact that ASU 2016-02 will have on borrowers and should be willing to modify their debt agreements to address these changes in accounting principles. Similarly, there should not be a significant impact on credit ratings, as credit rating agencies frequently factor in obligations related to off-balance sheet leases.
In summary, the aforementioned new lease accounting changes are fast approaching and will significantly impact financial reporting and increase the data required to accurately account for and disclose leases in financial statements. Companies should proactively determine the impact of ASU 2016-02 and work with their investors, lenders, lessors, regulators, boards of directors, and other interested parties to inform them of the specific impact; implement a comprehensive action plan to address the impact in order to avoid negative unforeseen consequences; and negotiate the most favorable lease terms from an operational standpoint, without regard to the resulting liability (and corresponding right to use asset).