New Lease Accounting Standards Come with Plenty of Gotchas
The recent leasing rules from the Financial Accounting Standards Board and the Governmental Accounting Standards Board are turning out to be harder to follow than many organizations expected.
Not only do the new leases standards, FASB’s ASC 842 and GASB’s Statement No. 87, require entities to put operating leases on the balance sheet for the first time ever, but they come with extra complexities. Entities will need to evaluate all contracts relating to the right-to-use assets for recognition in financial statements. Meanwhile, GASB 87 requires all leases be reported as financing activities, which affects how entities report expenditures in governmental funds. Other areas such as quick ratios, debt ratios, and earnings before interest, taxes, depreciation and amortization, or EBITDA, can be affected as well, and they could have an impact on future compliance with an organization’s current loan covenants or its ability to secure new financing.
Many organizations have yet to comply with the new standards.
“Most people have no clue that this is going to take more time and money and be more expensive to implement than they could ever have imagined,” said Walker Wilkerson, managing principal of national assurance at CliftonLarsonAllen. “If you’ve seen people who have been involved in the process and you have 100 contracts you have to go through, that takes a lot of time. You may not have the available staffing in order to be able to do that, so you might have to outsource some of those functions. Then if you’re purchasing new software in order to help you account for it, that’s an additional expense that a lot of people haven’t thought about. If they’re trying to do that at the 11th hour, they’re probably not going to be successful.”
A recent survey by LeaseCrunch, a provider of lease accounting software, found that 41% of GASB and non-public FASB clients have not yet completed implementation of the new GASB lease standard, which is supposed to be implemented for fiscal years starting after June 15, 2021. Nearly half (48%) of clients said they won’t adopt early implementation of the new leases standard. Incremental borrowing rates (50%), lease terms (28%), and fair values and effective lives (9%) were cited as the three top problems facing respondents. The survey found 22% of the respondents have not completed their lease inventory, and over 80% said their clients’ leases had been affected by COVID-19.
FASB has repeatedly delayed the leases standard for private companies, most recently because of the outbreak of the COVID-19 pandemic last year, when it also moved to postpone the effective dates for some of its other major standards. Publicly traded companies were already expected to begin implementing the standard before the pandemic began spreading across the country, but the deadline is approaching soon for privately held businesses. They are expected to include most leases on their balance sheets for fiscal years starting after Dec. 15, 2021 (that is, for calendar periods beginning Jan. 1, 2022). But according to a separate poll by Deloitte in April, nearly one-fifth (19.8%) of executives at privately held organizations feel unprepared to comply with FASB’s leases standard.
Having the right internal controls in place can help organizations deal with both the FASB and GASB leasing standards. “When it comes time to gather your total population of contracts for evaluation as potential leases being subject to the new lease standards, if they were to do just one tweak today with their internal controls and have a little bit of education about what the new lease standard is, every new contract that gets signed also gets evaluated for the potential applicability of the new lease standard, then you’re so far ahead of the game because you’ve already got 100% of a population going through your internal control structure, and whenever you get to the end of the year you’ll know exactly how it’s going to impact your financial statements,” said Wilkerson.
Debt covenants and debt service ratios will also be affected by the new standards. “Whenever we look at the ways that a financial institution would have calculated your ratios last year, well, it’s not going to be the same number this year,” said Wilkerson. “I’ve heard arguments saying, ‘Oh, I don’t have to worry about it because we signed that contract last year and it’s under legacy GAAP, so we’re fine.’ Well, OK, that’s probably true, but if you signed that identical contract this year or whenever you’re in the year of implementation of new GAAP, well, guess what? Now you’re bound to the new GAAP. One of the clauses I’ve seen periodically says that you can’t enter into new debt without that financial institution’s authorization. Well, we’re getting ready to put new debt on the books with that lease agreement, so to me those are some very compelling reasons for people to start today and not to wait around.”
Financial institutions and government entities will need to be careful with how the information is reported on the balance sheet. “We’ve got to make sure that financial institutions and other places understand how this is going to impact them too,” said Wilkerson. “Governments are often issuing bonds and seeking financial investors just like some private companies, and it’s going to look different in the future. A lot of folks are not going to restate. They’re going to have a single-year presentation. That could cause problems too. It’s not going to be just as simple as, ‘Oh, let me look at last year this year,’ because there could potentially be some material changes. And that could make a financial investor make a different choice this year than they made last. Probably my biggest concern on that one is that whenever the people are entering into the new agreements that have the same exact covenants that they did last year, with the same ratios, they’re just not taking into consideration how this is going to impact them.”
Businesses will need to keep a close watch on how they report EBITDA and various debt ratios. “If you’re buying or selling a business, that’s going to impact the price,” said Wilkerson. “People need to understand the impact of these new leases, because geographically they could show up in different places. Whether it shows up as an interest expense or whether it shows up historically as just an operating cost, that could change that computation if it’s a significant number. A lot of people don’t really think too much about that particular ratio, but especially if you’re transacting business to buy or sell entities, that’s another number to watch. You might go off of historical factors, and that might not be the right answer for the entity that you’re looking at because of the change in the way that the operating expense vs. the interest expense is dealt with.”
Investors will be keeping a close eye on the debt service ratio and the debt to net worth ratio when leases go on the balance sheet for the first time at businesses. “If we think about the impact on the balance sheet, day one when we put the right to use asset and the liability, they’re equal amounts in most cases,” said Wilkerson. “We had no impact on equity at that point, so we had an asset and we had a liability. Whenever we had that computation before, we didn’t have that liability because all it is is basically taking the amount of the debt divided by equity. Now we’re putting on more debt so we know that ratio is going to worsen at that point. Same thing with the current ratio because, again, it’s looking at current assets and current liabilities, so whenever we put on the new assets, it’s a noncurrent asset so it doesn’t get into the the numerator, but when we put on the debt, a portion of it is going to be current so that is going to wind up going into our denominator, so that’s going to make that ratio much worse. All of these are going to be negative impacts. None of them is going to be positive. There’s no way to get a positive ratio movement out of putting this on the books.”
For large public companies, financial analysts have long known how to take into account the impact of their leases, even before public companies were required under the new standard to include them on the balance sheet when interpreting the numbers for investors. But most private companies don’t have that level of expertise in being able to take the leases into account and explain them to banks and other sources of financing.
“What we’re finding is that most folks don’t even know the question to ask,” said Wilkerson. “They know that they have debt covenants, but predominantly they don’t understand how this is going to impact them. They’ve signed these debt covenant contracts and loan agreements in the past, and they’re going to sign that exact same one again this year, and it’s going to have a very different output and they need to understand the differences before they sign it. They can’t just rely on financial institutions to figure it out for them.”
At CLA, he is trying to urge clients to prepare for the changes ahead. “We’re really trying to help people understand what it’s going to take in order to get it done,” he said. “They need a plan. It’s going to take more time and money than they expect. They don’t have the internal controls to deal with it today, and they need to understand the impact of their financial reporting. That helps lead them into the planning process. If you don’t have a plan, then you’re planning to fail.”
He recommends that clients first identify all of their leases, including “embedded leases” that might not seem so obvious from the contract.
“It’s not just the ones that say lease on them,” said Wilkerson. “We also have to deal with those that don’t: the service contracts that may have an embedded lease. That’s where we’re seeing the most difficulty in implementation. It’s helping organizations find those embedded leases, and they’re all over the place.”
Banks, for example, often don’t own the ATM machines they provide, but lease them from a service company. Large hospitals often have industrial size ice machines on the premises that are owned by an outside vendor with whom they have an ice service contract.
Similarly, many offices have coffee machines that they lease from outside vendors, though they probably won’t need to include the coffee maker on their balance sheet. “Unless it was something super expensive, you wouldn’t even consider it,” said Wilkerson. “But use that example to think about other things with embedded leases. Every industry that I’ve talked to has something that’s unique to them and applicable, and those things can take hours to unwind.”
(Source: AccountingToday – Best of the Week – July 10, 2021)