This article was original published in the February 2020 Career Education Review and reproduced here with permission. Article originally posted at careereducationreview.net.
Remember the scene from the movie “2001: A Space Odyssey” in which it takes an astronaut what seems like forever to move across the scene? As a CPA, the implementation of Accounting Standard Update 2016-02: Leases (Lease Standard) from preliminary discussions, the long process of a proposed standard, agreement and disagreement on the proposed standard, the issuance and delay of the final standard, and the U.S. Department of Education’s (ED) changes to the composite score ratio (CSR) calculation have reminded me of this cinematic moment. You know eventually the regulation’s impact will occur, and yet it has taken a decade to get to this point.
As a quick refresher, the Lease Standard will require all leases over one year to be recognized on a company’s balance sheet as a Right-to-Use asset (RUA) and a Lease Liability (LL). A company will need to determine whether the RUA and LL is a finance lease or an operating lease. The result of whether the lease is a finance or operating lease should have minimal impact on the income statement, as the expense component of a finance lease will be recognized similar to the current capital leases and the operating lease expense component will be consistent with current operating leases. However, for both types of leases, there will be a significant change on the balance sheet for most companies. For institutions of higher education, one of the biggest concerns is the impact the RUA will have on the annual CSR calculation.
With ED’s issuance of the 2018 final Borrower Defense to Repayment regulations, institutions now have a roadmap for the treatment of the RUA and the LL in the annual CSR calculation.
Institutions are under the following timeline:
- The Lease Standard becomes effective for years beginning after Dec. 15, 2020, for nonpublic entities. If your fiscal year-end is Dec. 31, the effective date is for the year ended Dec. 31, 2021. If your fiscal year-end is June 30, the effective date is for the year ended June 30, 2022. Update: Due to the ongoing pandemic, the AICPA has extended both effective dates one year and are now December 31, 2022 and June 30, 2023, respectively.
- ED’s guidance indicates that leases which are signed, renewed, extended or modified after Dec. 15, 2018, are included in the CSR upon the Lease Standard becoming effective.
- Leases which are executed prior to Dec. 15, 2018, are excluded from the CSR until the leases are renewed, extended, or modified, as noted above.
As such, all nonpublic entities have a planning opportunity over the next couple of years to review the impact of the Lease Standard before any change occurs to the CSR calculation. For our clients, real estate leases will be most affected by the new standard. The reason is that currently these are usually accounted for as operating leases and have no balance sheet impact. For equipment leases, some are already treated as a capital lease, and equipment leases accounted for as operating leases normally aren’t material to the financial statements.
This is the crux as to why planning now is important.
Let’s review some of the planning opportunities.
ED’s guidance indicates that the RUA and the LL will be treated the same as property, plant and equipment (PPE), and long-term debt (LTD), respectively, in the CSR calculation. Therefore, no impact on the Primary Reserve Ratio will occur as the increase in PPE and LTD as a result of the RUA and the LL will offset. However, adding the RUA to the balance sheet increases total assets, which has a detrimental effect on the Equity Ratio since the denominator is total assets. Thus, institutions should evaluate planning opportunities surrounding the lease length, lease payment amount, incremental borrowing rate, lease incentives and tenant improvement allowances.
The first item to consider is the length of the lease. The RUA is computed using the term of a lease. For example, a 15-year lease would require all 15 years to be included in the calculation of the RUA. In contrast, a lease which is five years long with two five-year renewal options, depending on the facts and circumstances, might not have to include all 15 years. Upon signing or modifying the lease in this example, management would need to evaluate the likelihood of exercising future renewal options. Periods subject to lease renewal options would not be included as part of the term of the lease, unless economic factors indicate it would be reasonably certain at the time of signing the lease that the option would be exercised. Thus, in the example above, based on fact and circumstances, management could record the first five years and potentially the second five-year option but possibly not the third five-year option. The third five-year option may not need to be recognized on the balance until such time it is reasonably certain it will be exercised. This is an area that will require management’s judgment and the conclusion reached should be documented to support the position taken. Any renewal periods which don’t need to be included at the inception or modification of a lease lowers the RUA and improves the CSR calculation.
As a caveat, management should remember that any leasehold improvements capitalized by the institution need to be amortized over the lesser of the useful life of the improvements or the term of the lease. In the example above, if management has determined that only the initial five-year lease period and the first five-year option period is reasonably certain at the time of commencement, new leasehold improvements would only be amortized over the remaining term, in this case, a 10-year lease. Management could not amortize these improvements over 15 years, as this would be inconsistent with the RUA and LL conclusions. At the time when management concludes the second five-year renewal period is reasonable and remeasures the RUA and LL, then the remaining period of the unamortized balance of the leasehold improvements could be extended by five years as a change in accounting estimate.
The next planning opportunity is the lease payment. The calculation of the RUA includes all the future lease payments. The lease payment amount is defined in the lease agreement. If insurance, real estate taxes and common area maintenance charges are included in the lease payment, then these amounts are included in the calculation of the RUA. However, the Lease Standard excludes these items from the RUA if they are separate from the lease payment. Management should ensure that lease agreements separate any operating or pass-through costs from the actual lease payments. If not, management would need to allocate the lease payments into separate lease and non-lease components based upon their relative, observable standalone prices. These prices can be estimated by management if observable standalone prices are not readily available. A practical expedient exists, which enables the lessee to make an accounting election to not separate non-lease components from lease components and account for the payment as a single lease component. While this is a simpler approach, this would lead to a higher RUA. M&A recommends that management have lease and non-lease components separately identified in the lease agreement or ensure than management has obtained observable standalone prices in order to separate lease and non-lease components.
The third planning opportunity is the incremental borrowing rate. The RUA represents the present value of the future lease commitments. A company is required to utilize the incremental borrowing rate for the property, which is similar to the property being leased. An institution which doesn’t have any long-term debt or doesn’t have long-term debt similar to the property being leased (i.e., real estate) may not have an easily identifiable incremental borrowing rate. The Lease Standard allows a nonpublic entity to use a risk-free rate as a practical expedient. However, a risk-free rate would be lower than an incremental borrowing rate and will lead to a higher RUA. This is detrimental to the CSR calculation. A lessee may determine a single discount rate to a portfolio of leases assuming the impact of applying to each lease in the portfolio is not materially different. For example, if the determined incremental borrowing rate would be relatively consistent for all real estate leases, then this rate could be used for all real estate leases when computing the RUA and the LL. An institution’s management should consider discussing this incremental borrowing rate with an existing creditor or engaging a third-party company to compute an incremental borrowing rate especially as related to real estate leases. An institution may have a history of utilizing capital leases and debt for equipment purchases, and little history may exist for real estate purchases. While a cost will exist for this service, the benefit to the CSR calculation could be worthwhile.
When negotiating a lease, an institution may obtain a lease incentive as an inducement to sign the lease. Lease incentives are recorded as a reduction of the RUA. Thus, this incentive is not recognized immediately as revenue (expense reduction) and is recognized over the length of the lease in lower amortization expense as a result of the reduced RUA. Management needs to ensure that any lease incentive which is received is not passed back through to the institution in the form of higher rent expense. This would increase the RUA and offset any benefits received from the lease incentive.
The final item of consideration relates to tenant improvement allowances (TIA). Under the Lease Standard, the overall treatment of a TIA is similar to the existing accounting standards. The specific details of the transaction (intent of the payment, ownership of the leasehold improvements, tenant discretion and control, required construction disclosures) impacts the accounting treatment. The TIA needs to be evaluated to determine whether it truly is a TIA or if is it a lease incentive. In addition, a determination needs to be made as to whether or not the landlord is actually financing the TIA by increasing the rent payment. This needs to be evaluated during lease negotiations so any impact on the CSR calculation can be computed.
As a side note, little guidance exists regarding related-party leases. For many nonpublic companies, the real estate may be held in a common control entity due to tax and liability reasons. In these cases, if a formal lease exists due to the third-party creditor requiring a lease to support the mortgage debt on the common control entity, then the institution will need to recognize the RUA and the LL. Under the Lease Standard, related party leases should be evaluated on the basis of legally enforceable terms and conditions of the contract rather than the substance of the agreement. Therefore, if no formal related party lease exists or the lease is one year or less, the current guidance seems to indicate the RUA and the LL will not be recognized in the financial statements.
The new Lease Standard will have a significant impact on the financial statements and CSR of institutions, especially due to the real estate leases. Management should ensure that during lease negotiations these variables are taken into consideration and reviewed to enable accurate CSR projections. With many leases being 5 to 10 years in length, once the lease is signed and in place, the impact on the institution will be set. Accurate planning is essential and should be performed in advance of the Lease Standard’s effective date.