Note: This article was first available to subscribers of Accounting Quality Insights by Audit Analytics on Bloomberg, Eikon, FactSet, and S&P Global.
Now that the new lease accounting standard ASC 842 is effective, we see that public companies are progressing very slowly to adopt the measure. The analysis below is based on filings dated between October and December of 2018 for the examined population of S&P 500 companies.
The Financial Accounting Standards Board (FASB) issued the standard in February 2016, but it didn’t come into effect until 2019 for companies with calendar year-ends. The new rule says companies must recognize lease assets and liabilities on their balance sheet. According to the FASB, the new standard should improve financial reporting of leasing transactions.
To better understand why this change in accounting was required, let’s first look at the historical requirements. Previously, companies did not have to report operating leases on the balance sheet, raising the argument that for some companies, liabilities might be underestimated by billions. The outstanding lease commitments were typically disclosed in the footnotes to financial statements. Yet, the new presentation is more transparent from the investor’s perspective. With the implementation of the new standard, the accounting for capital leases is largely unaffected.
The new rule affects both lessors and lessees, and before the rule is implemented, these entities must evaluate the impact of the new standard on their business processes, financial statements and internal controls.
When FASB issued the rule, it changed the definition of a lease. Under ASC 842, a lease means that “the contract conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration.” In contrast, under the previous accounting rule – ASC 840 – a lease was defined as an agreement conveying the right to use property, plant or equipment.
On the surface, the definitions look very similar. Yet, under ASC 842 a lease must identify the asset, the lessee must receive most of the economic benefit, and the lessee must have the right to say how the asset will be used. All leases, except for short-term leases of 12 months or less, are reported on balance sheets, unless it fails to meet the definition of a lease.
While the new lease definition sounds simple, it’s actually a big change and a challenge for the accounting and operations. The new standard applies to large items such as office space or cars, but also to small things like leased equipment or even software, so companies will have to install new software to properly track the leases. Failure to do so could cause internal controls to be ineffective and, in some extreme cases, if a material lease was not accounted for properly, may even cause financial statements to be incorrect.
Implementation Progress
So far, only two S&P 500 companies early-adopted the new standard – Microsoft Corp. [MSFT] and Target Corp. [TGT]. This rule is complex, so it is not surprising that only two companies have adopted the standard early.
Six companies disclosed the new standard will have an impact on internal control over financial reporting (ICFR), while 91 companies (18%) disclosed that new software will be implemented associated with the adoption of the lease standard. The standard does allow for certain simplifications, and so far about 150 companies indicated that they are planning to use practical expedients to reduce the cost and complexity of implementation.
To implement the standard, companies can use either a prospective method or a modified retrospective method.
Modified retrospective method requires the restatement of previously filed financial statements and provides comparability between periods. The disadvantage of this method is high implementation costs. In June 2018 the FASB issued a simplification update ASU 2018-11 that, among other provisions, allows companies not to recast previously filed financial statements. Instead, companies can elect to record the impact of the standard as of the date of the adoption, which is January 1, 2019 for the calendar year-end companies.
Not surprisingly, more than half of the companies already indicated that they are going to use the relief provided by the FASB and apply the prospective method. A number of firms have not indicated what they will do yet, but it is safe to assume that the final number of prospective applications will increase as the implementation deadline gets closer.
Impacts of New Standard
We expect the standard will have a material balance sheet impact on about 80% of companies, particularly on the right-of-use assets. Let’s look deeper at how the rule might reverberate and the potential major impacts of the standard. Below we list the type of policy impacts ASC 842 may have on companies.
In addition to the impact on accounting policies, the new rule will have a substantial financial impact on public companies as it will add millions, and in some cases, billions, in liabilities to corporate balance sheets, where liabilities and debt offset assets. Other areas analysts and investors should look at for possible impacts are on expenses, debt covenants and on capital ratios.
Of S&P 500 companies where the new rule has a balance sheet impact, we have seen a nearly even split between the financial impact to assets and liabilities. The standard will likely impact assets and liabilities equally for most companies, as there is a right-of-use asset with a corresponding operating liability. Keep in mind, how the new rule affects balance sheets may change over time as more firms disclose.
Some impacts, such as the recording of right-of-use assets and a corresponding operating lease liability are widely discussed and mostly well understood. In the discussion below, we primarily focus on less known provisions that may nevertheless be very material for some companies.
Build-to-Suit Arrangements
A less common type of lease accounting are “build-to-suit” arrangements. Often seen in property leases, a developer will build according to a tenant’s specifications, in order to suit the needs of the tenant. These are sale-and-leaseback transactions, where a seller transfers the asset to a buyer, and the seller leases it back from the buyer.
The new standard makes significant changes to current rules.
- The asset transfer must meet the definition of a sale
- The leaseback must not be considered a sales-type lease or a finance lease
- The contract needs to include a repurchase option
- The repurchase option price must be a fair value of the asset and similar in price to other alternatives available on the market
Many build-to-suit arrangements are not likely to be considered leases under the new standard and will be off the balance sheets. One example of build-to-suit arrangements that will no longer be recognized are the solar-energy leases for Tesla, Inc. [TSLA], which we’ve written about previously. The car company made news in its fourth-quarter earnings when discussing how the new standards will affect parts of its business. Tesla’s solar-energy leases will now be accounted for under ASC 606 because they will no longer meet the threshold for lease accounting when ASC 842 is implemented.
There are unique examples where lease arrangements may still affect liabilities. Southwest Airlines Co. [LUV] has assets and liabilities for build-to-suit arrangements on their balance sheet that are expected to be derecognized. However, one project that will be recognized as a lease liability is related to bond payments at Southwest’s main hub in Dallas, as it meets a specific requirement to remain on the balance sheet (the emphasis is ours):
In addition, the New Lease Standard eliminates the current build-to-suit lease accounting guidance and is expected to result in derecognition of build-to-suit assets and liabilities that remained on the balance sheet after the end of the construction period. See Note 7 for further information on the Company’s build-to-suit projects. However, given the Company’s guarantee associated with the bonds issued to fund the Dallas Love Field Modernization Program (the “LFMP”), the Company believes that the remaining debt service amounts as of the adoption date would be considered a minimum rental payment under the New Lease Standard, and therefore will be recorded as a lease liability on the balance sheet and will be reduced through future debt service payments made in 2019 and beyond. The underlying leases for all of these facilities will be subject to evaluation under the New Lease Standard.
Capitalized Expenses
Under ASC 842, FASB changed how it defines indirect costs when it comes to lease origination costs. This could mean there will be fewer indirect capitalized costs. Executory costs, like property taxes or insurance, will be considered part of lease payments. One example is Federal Realty Investment Trust [FRT] which notes that some indirect lease expenses that were previously capitalized will now be expensed:
Additionally, we will no longer be able to capitalize certain internal leasing and external legal leasing costs. For the nine months ended September 30, 2018, we have capitalized approximately $5.3 million of internal leasing and external legal leasing costs, of which a portion will be expensed when we adopt ASU 2016-02.
Corporate Debt Ratios
Because the new standard requires companies to report operating leases as liabilities, it can affect debt-to-earnings ratios and thus, loan covenants. Most loan covenants are written based on the GAAP rules in place when the loan is created. If a new GAAP accounting method is implemented, such as the new ASC 842 standard, debt ratios need to be recalculated. That could make it more difficult for companies to borrow money. It could lead to some companies needing to renegotiate loan terms or maintain another set of books. That means until the loans are due, they would need to run special reports for their creditors using the GAAP rules that were previously valid under the loan terms, but not with current GAAP rules that include the new ASC 842 rules. Financial reports run by companies that go to regulators and investors will follow the updated standards.
Bank Capital Requirements
The new standard will affect bank capital ratios, the amount of money that regulators require banks to hold. Intangible assets are deducted from bank capital ratios, while tangible assets are not. There is no specific guidance under ASC 842 on whether right-of-use assets are considered tangible or intangible assets. Deloitte suggests banks look to how the Basel Committee on Banking Supervision regards right-of-use assets. Basel considers right-of-use assets tangible because the underlying asset is tangible and should be risk-weighted at 100%.
Wells Fargo & Company [WFC] considers that its right-of-use assets will increase its risk-weighted assets and decrease its capital ratios:
We expect to adopt the guidance in first quarter 2019 using the optional transition method without restating 2018 and 2017 financial statements with comparable amounts. At adoption, we expect to have a cumulative effect adjustment of approximately $140 million to increase retained earnings related to deferred gains on our prior sale-leaseback transactions. The calculation of our operating lease right-of-use assets and liabilities, for approximately 7,000 leases, are expected to be $5 billion and $5.6 billion, respectively, and will continue to be refined as we complete our implementation process. We do not expect material changes to the timing of expense recognition on our operating leases or the recognition and measurement of our lessor accounting. While the increase to our consolidated total assets related to operating lease right-of-use assets will increase our risk-weighted assets and decrease our capital ratios, we do not expect these changes to be material.
In conclusion, we expect to see a lot more discussion related to how companies are defining leases and how they plan on implementing the new standard throughout the year.
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