By Pete Miller, CPA, CFE
April 21, 2020 update: To provide accounting relief and clarity during the COVID-19 crisis, the FASB published an exposure draft with proposals to delay the effective dates for Leases (Topic 842). Find more information here.
Many companies worldwide will soon take a different view of their balance sheets. Entities that pay to lease real estate, airplanes, office equipment, fleet vehicles and other items will be required to recognize significant debt-like obligations and add billions onto their balance sheets.
After more than a decade of drafts, surveys and redrafts of the Lease Accounting Standards, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) have finally set effective dates for leaseholders to adopt the respective Lease Accounting Changes. FASB issued Accounting Standards Update (ASU) 2016-02 earlier this year. The new guidelines are outlined in the Accounting Standards Codification (ASC) Topic 842 and take effect December 2018. IASB’s changes, outlined in IFRS 16, take effect January 2019.
What Does the Change Mean?
Simply stated, the new standards require lessees to convert their operating leases (off-balance sheet) to capital leases (on-balance sheet), which reflects the lease’s liability (rent).
Although the standards may seem onerous and complex, the overall goals of the proposed changes are simple – to create more transparency of a company’s assets and liabilities and avoid the accounting scandals that have plagued world economics. Of particular concern was the possibility of abuse of off-balance sheet reporting of liabilities. FASB is trying to create transparency by taking a very common and significant economic and legal liability (the obligation to make lease payments), which is often reported off the balance sheet (particularly with office leases), and create consistency by making everyone report it on the balance sheet.
Variables – Altered Capital and Disclosures?
The addition of lease liabilities to the balance sheet is expected to have a significant impact on financial ratios relied upon by the users of a company’s financial statements (i.e., investors, lenders, etc.). So, will these new rules create consistency for all? Not necessarily. Although all companies will play by the same rules, not all companies’ financial ratios will be affected in the same manner.
Industries with modest leasing needs will appear to be performing better than those with higher leasing needs (such as retail, manufacturing, aerospace and healthcare). However, this doesn’t mean that companies with heavy leasing needs will suddenly become a poor investment choice. It is important to understand that investors, lenders and analysts will need to re-calibrate their metrics as a result.
Financial ratios to pay attention to include:
- Debt to Equity (D/E) – The debt to equity ratio is used to measure the amount of leverage, or debt, used in the business. This new standard will result in adding assets and liabilities to the balance sheet, with no impact on equity, which will cause a spike to the D/E ratio. With a higher leverage ratio, this is sure to cause discussion between companies and their lenders.
- Return On Assets – Return on assets is used to measure a company’s return on the investment it makes in its assets. This ratio will take a hit as companies add assets to the balance sheet. Overnight, assets will rise and earnings will stay the same, causing the return as a percentage of those assets to decline.
- Working Capital – As a measure of a company’s ability to pay its current liabilities with its current assets, the addition of the portion of leases to be paid over the next year to current liabilities will definitely skew the working capital ratio.
Important, but Not Important
Companies have generally taken the liberty of burying their lease obligations deep within the Form 10-K footnotes. Because finance and capital leases are already accounted for, it’s primarily the operating leases that need to be reflected on the balance sheets. This practice shouldn’t have much of an impact on corporate profits, and none of this should come as a surprise to the ratings firms and large institutional investor who typically have the off-balance sheet assets and liabilities already accounted for. It’ll be the small investors who don’t have the resources or experience to scrub through the massive amounts of footnotes who will generally be surprised by the changes.
But let’s not let the tail wag the dog. The idea of moving lease assets and liabilities onto the balance sheet just isn’t that important throughout the financial and accounting circles. It’s acknowledged as more of a laborious headache than a safeguard of checks and balances.
Take a Back seat!
What’s important when taking on a leased obligation is that companies negotiate and structure the best deal possible. Why? Because the goal of the new standards is to create transparency – not provide any benefits or leverage to either the lessor or lessee.
While the accountants and finance people should work out the details, there needs to be open and frequent conversation between a company’s different groups (accounting, finance, treasury and any other department(s) responsible for the obligations of the lease). This will ensure that all goals and objectives are met. The proposed accounting changes might not change the outcome of the leasing decisions made by a company, but it’s certain to change the process companies undertake to come to consensus on the decisions.
The two primary goals companies take into consideration when negotiating a lease are to satisfy operational needs and meet financial objectives. Two variables govern these goals:
- Lease Versus Buy – With the knowledge that the assets will transfer to the balance sheet, companies will need to consider if it’s advantageous to continue leasing or instead purchase the asset. Companies can benefit from tax benefits through depreciation over the asset’s life or factor depreciation over the lease term.
- Lease Term – It may be tempting to negotiate a shorter lease term to lessen the impact the lease obligations will have on the balance sheet, but be careful! Short lease terms will generally cause higher rental rates. Concentrate on cash flows and negotiate the lease that will provide the best cash flow result.
Leasing should provide flexibility, so don’t become handcuffed with terms and conditions that don’t consider your company’s best interest. Negotiate the best deal for your company and let the accounting and finance people work out the details.
There will be many decisions for companies to make over the next few years to best structure their entities for a smooth transition while continuing to provide shareholder value.
With the issuance of the standards this year and (only) 2 ½ years before companies must start reporting under the new guidelines, there are mixed emotions about jumping in knee-deep and engaging new systems, policies and procedures – remember Sarbanes-Oxley?
Executives of many companies were uncertain of the magnitude and cost associated with implementing the Sarbanes-Oxley compliance measure. It’s no wonder company leaders aren’t motivated to dive into the new lease accounting standards.
Preparation, communication and execution are the fundamentals every company needs to address. Financial executives within companies will need to study the new guidance and assess the impact on their financial statements well ahead of the switch-over date. Ratios involving cash flows and Earnings Before Interest Taxes Depreciation and Amortization (EBITDA) will be unaffected, but those involving balance sheet accounts will likely be impacted heavily.
The time is now to assess if the company has the resources/staffing and financial capacity to handle this task in-house or if the work should be outsourced. It is also time to understand the severity of the impact this will have on balance sheets and to develop a communication strategy with investors and lenders so there are no surprises.
Consult your CPA if you have any concerns or questions about the new guidance. The long-anticipated standards for transparency and consistency in lease accounting will be here sooner than you think.
© Clark Nuber PS and Adam Milhlstin, 2016. All Rights Reserved