New lease accounting standards have many pitfalls
The recent Financial Accounting Standards Board and Governmental Accounting Standards Board leasing rules are proving more difficult to follow than many organizations have thought.
Not only do the new leasing standards, FASB ASC 842 and GASB Statement 87, require entities to record operating leases on the balance sheet for the first time, but they come with additional complexities. Entities will need to assess all contracts relating to the right to use assets for recognition in the financial statements. Meanwhile, GASB 87 requires that all leases be reported as finance activities, which affects how entities report expenditures in government funds. Other areas such as rapid ratios, debt ratios and earnings before interest, taxes, depreciation and amortization, or EBITDA, may also be affected, and they could impact future compliance with loan commitments. current organizations or its ability to secure new funding.
Many organizations still have to comply with the new standards.
“Most people have no idea that this is going to take more time and money and be more expensive to implement than they ever could have imagined,” said Walker Wilkerson, senior manager of National Insurance at CliftonLarsonAllen. “If you’ve seen people who have been involved in the process and you have 100 contracts to go through, it takes a long time. You may not have the staff available to be able to do this, so you may need to outsource some of these functions. Then, if you buy new software to help you factor it in, that’s an added expense that a lot of people haven’t thought of. If they try to do it by the 11th hour, they probably won’t.
A recent survey by LeaseCrunch, a provider of lease accounting software, found that 41% of GASB and non-public FASB clients have yet to complete the implementation of GASB’s new lease standard, which is expected to be implemented for fiscal years beginning after June 15, 2021. Almost half (48%) of clients said they would not embrace early implementation of the new lease standard. Additional borrowing rates (50%), lease terms (28%) and actual fair values and lives (9%) were cited as the top three issues facing respondents. The survey found that 22% of respondents had not completed their lease inventory, and more than 80% said their clients’ leases had been affected by COVID-19.
The FASB has repeatedly delayed the standard of leases for private companies, most recently due to the outbreak of the COVID-19 pandemic last year, when it also decided to postpone the effective dates of some of its other major standards. Listed companies were already expected to start implementing the standard before the pandemic began to spread across the country, but the deadline is approaching soon for private companies. They are expected to include most leases on their balance sheets for years starting after December 15, 2021 (i.e. for calendar periods starting January 1, 2022). But according to another poll by Deloitte in April, nearly a fifth (19.8%) of heads of private organizations feel ill-prepared to comply with the FASB’s hiring standard (see the story).
Having the right internal controls in place can help organizations manage both FASB and GASB rental standards. “When it comes time to assemble your total population of contracts to be evaluated as potential leases subject to the new lease standards, if they were to make a single adjustment today with their internal controls and have a little education on that that the new lease standard is that each new contract signed is also assessed for the potential applicability of the new lease standard, then you are so far ahead of the game because you already have 100% of a population going through your internal control structure, and every time you get to the end of the year, you’ll know exactly what the impact will be on your financial statements, ”Wilkerson said.
Covenants and debt service ratios will also be affected by the new standards. “Anytime we look at the ways a financial institution would have calculated your ratios last year, well, it won’t be the same number this year,” Wilkerson said. “I’ve heard arguments saying, ‘Oh, I don’t have to worry because we signed this contract last year and it’s traditional GAAP, so it’s okay.’ Well, okay that’s probably true, but if you’ve signed that identical contract this year or every time you’re in the year of implementing new GAAP, well guess what? You are now bound to the new GAAP. One of the clauses that I consulted periodically said that you cannot contract new debts without the authorization of this financial institution. Well, we’re getting ready to put new debt on the books with this lease, so I think these are very compelling reasons for people to start today and not wait.
Financial institutions and government entities will need to be careful about how information is reported on the balance sheet. “We have to make sure that financial institutions and other places also understand how this is going to affect them,” Wilkerson said. “Governments often issue bonds and seek financial investors, as do some private companies, and things will be different in the future. A lot of people are not going to rephrase. They will have a one year presentation. It could also cause problems. It won’t be as simple as “Oh, let me look at last year this year” because there could be some big changes. And that could cause a financial investor to make a different choice this year than they did last year. My biggest concern about this is probably that every time people make new deals that have exactly the same commitments as last year, with the same ratios, they just don’t take into consideration the impact that’s going to be. have on them. “
Companies will need to closely monitor how they report EBITDA and various debt ratios. “If you buy or sell a business, it will impact the price,” Wilkerson said. “People need to understand the impact of these new leases, because geographically they could appear in different places. Whether it’s an interest expense or a simple operating cost historically, it could change that calculation if it’s a large number. A lot of people don’t really think about this particular ratio, but especially if you are doing transactions to buy or sell entities, this is another number to watch out for. You could be moving away from historical factors, and that may not be the right answer for the entity you are looking at due to the change in the way operating expenses versus interest expenses are treated.
Investors will keep a close eye on the debt service ratio and debt-to-equity ratio when leases are first recorded on the balance sheet in companies. “If we think about the impact on the balance sheet, the first day we put the right to use assets and liabilities, they’re equal amounts in most cases,” Wilkerson said. “We had no impact on equity at this point, so we had an asset and we had a liability. Whenever we had this calculation before, we didn’t have this responsibility because it’s basically taking the amount of debt divided by equity. Now we are in more debt, so we know that ratio is going to get worse then. Same thing with the current ratio because, again, it looks at current assets and current liabilities, so anytime we put on new assets it’s a non-current asset so it doesn’t go into the numerator, but when we put on debt, some of it will be up to date, which will eventually go into our denominator, which will make that ratio much worse. All of these will be negative impacts. None of them will be positive. There’s no way to get a positive ratio move by putting this on the books.
For large SOEs, financial analysts have long known how to factor in the impact of their leases, even before SOEs are required under the new standard to include them on the balance sheet when interpreting numbers. for investors. But most private companies don’t have that level of expertise to be able to take leases into account and explain them to banks and other sources of finance.
“What we’re finding is that most people don’t even know the question to ask,” Wilkerson said. “They know they have restrictive covenants, but above all they don’t understand how it will impact them. They’ve signed these debt commitments and loan agreements in the past, and they’re going to sign the exact same one again this year, and the outcome will be very different and they have 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 tries to urge customers to prepare for the changes ahead. “We are really trying to help people understand what it will take to do it,” he said. “They need a plan. It will take more time and money than expected. They don’t have the internal controls to deal with it today, and they need to understand the impact of their financial reports. This helps them to engage in the planning process. If you don’t have a plan, then you plan to fail.
He recommends that clients first identify all of their leases, including “integrated leases” that might not seem so obvious from the contract.
“It’s not just the people who say they praise them,” Wilkerson said. “We also have to deal with those who don’t: service contracts that may have a built-in lease. This is where we see the most difficulties in the implementation. It helps organizations find those integrated leases, and they’re everywhere.
Banks, for example, often do not own the ATMs they provide, but rent them out to a service company. Large hospitals often have industrial size ice machines on premises that are owned by an external supplier with whom they have an ice service contract.
Likewise, many offices have coffee machines that they rent from outside vendors, although they probably don’t need to include the coffee maker on their balance sheet. “Unless it’s something really expensive, you wouldn’t even consider it,” Wilkerson said. “But use this example to think of other things with built-in leases. Every industry I’ve spoken to has something unique and applicable to it, and these things can take hours to unfold.