As a parent, sending a child to school seems so far off when they are born. However, eventually the day comes, whether they (or you) are ready or not. Most parents spent multiple years preparing their child for school to make the transition a great experience for everyone: themselves, teachers, and child. The long-awaited accounting standards change to the recognition treatment of leases is eerie similar. If an institution has not been planning for this, the “first-day of school” could be ugly.
In February 2016, the Financial Accounting Standard Board (FASB) issued Accounting Standards Update 2016-02: Leases (Lease Standard). This is section 842 in the Accounting Standards Codification This has been a long-standing project to change how companies recognizes leases. After many interruptions and delays, the implementation is finally here. For years beginning after December 15, 2021, the long-awaited accounting standard regarding leases becomes effective. Thus, businesses with a December 31, 2022, year-end will be the first go-around of adoption. Post-secondary institutions should ensure they have this change on their radar and are analyzing the key impacts in advance of year-end, especially relating to the Department of Education’s (ED) financial responsibility standards.
For many years now, the FASB has wanted to have leases recognized on a company’s balance sheet like the purchase of property, plant and equipment (PPE). Prior to the new Lease Standard, noncancelable lease agreements were just a commitment disclosure in the footnotes. However, to align and be similar to International Accounting Standards, the Lease Standard will require recognition of an asset and a liability on the balance sheet based upon the noncancelable commitments. The FASB believes this will provide a clear picture of the health of a company by having these lease commitments recognized in the financial statements and not just as a disclosure in the footnotes.
Many nuances exist in the Lease Standard, so consider this overview:
- The lease commitment amount will be determined using a present value calculation. The calculation will yield a Right-to-Use Asset (ROU) and a Lease Liability (LL). The discount rate used should be the rate implicit in the lease. If this can’t be determined, then a risk-free rate or an incremental borrowing rate (IBR) can be used. The IBR is a rate the company would have to pay if borrowing on a collateralized basis for a similar term for the underlying property. Thus, the IBR will require a third-party to compute or the entity will need to obtain this rate from a lender, but it will result in a lower ROU and LL. A nonpublic entity can make an accounting policy election to use a risk-free rate, but it must be used for all leases in a specific asset class (e.g., buildings, equipment.)
- All leases greater than 12 months must be recognized on the balance sheet.
- Leases subject to the standard must have a specifically defined asset, such as a specific part of a building or a copier. An agreement for information technology hosting or services which enables the provider to swap out their servers utilized for the service would not fall under the Lease Standard since no defined asset exists. In addition, a service contract for a cafeteria would not be applicable.
- Two types of leases will exist: Operating and Finance. A Finance lease would be similar to existing capital lease definitions and an Operating lease is similar to current operating lease definitions. While some differences exist in the recognition of Operating and Finance leases, this should not have a material impact on the financial statements.
- The lease payment can bifurcate non-lease components such as insurance, property taxes, common area maintenance charges, etc. If these items are not broken out separately, an election can be made by asset class to include these as part of the lease payment but that will increase the RUA and the LL.
- Renewal option periods should be considered if reasonably certain to exercise.
- Other less frequent items, such as variable lease payments (not changes based upon set amounts or CPI increases), tenant improvement allowances, broker fees, purchase options if expected to be exercised, initial direct costs, etc. are figured into the calculation of the RUA and LL.
- Lease modifications need to be reviewed to identify if a separate contract exists (lease granted additional rights) or if the changes are not a separate contract (shortening or extending a lease).
- The Lease Standard did allow for a few transitional practical expedients. A company does not have to reassess whether a contract contains a lease, the lease classification (Operating or Finance), or reassess initial direct costs. However, these three items must be adopted as a package not individually. (Thus, the “hat trick” of transitional practical expedients for those hockey fans reading this article.)
- A final transitional practical expedient, which is not tied to the three above, allows the use of hindsight for items such as purchase options, terminations, extensions, etc. and to reassess going forward.
- The Lease Standard provides very little context for related party leases. Unlike the current lease standard, which requires substance over form, the new Lease Standard looks at the legal substance of the lease. Therefore, related party month-to-month leases and leases of 12 months or less seem to be exempt from the Lease Standard. Companies should assess if some other legal right or arrangement exists which requires the leasee to pay a related party landlord. While this may not be a true lease agreement, a legal structure (side agreement, guarantee, etc.) shouldn’t be ignored. Companies need to discuss leases structured in this manner with their advisors and auditors for consensus as to the ultimate treatment.
- The balance sheet must reflect a current portion of the LL, but the RUA is reflected as a long-term asset. Thus, any Current Ratio is negatively impacted.
From our work to assist institutions to adopt the Lease Standard, our initial takeaways are as follows:
- Most clients have leases related to buildings, copiers and possibly some equipment for trade programs.
- Building leases are Operating and copier/equipment leases could be considered a Finance lease depending on the term, lease amount, and purchase option. In addition, the copier leases are most likely not material, so the Operating versus Finance treatment will have little bearing on the financials.
- Various factors must be considered when assessing whether to include renewal options in the lease calculations, such as the number of locations, likelihood for the institution to move, potential impact of future regulatory changes and long-term plans, importance of the location to overall operations, the availability of other space in the institution’s market, improvements recently invested at the location, how many years remaining until the renewal would kick in, favorability of the renewal option terms, and relocation costs. This is a fact-and-circumstances test, and each lease must be reviewed on its own.
- Related party leases vary with some institutions having formal long-term leases, some month-to-month or great than 12-month leases, and others with informal arrangements. We are reviewing these on a case-by-case basis to understand the complete nature of the relationship.
While going through the process to recognize leases on the balance sheet takes time and has a cost associated with it, the biggest concern for institutions is the impact on the composite score ratio (CSR), which is part of ED’s financial responsibility standards. The Lease Standard creates two hurdles in the CSR. One is that the Equity Ratio (ER) component has total assets as the denominator. Thus, any RUA recognized on the balance sheet increases total assets. The second is that the RUA is subtracted from the numerator in the Primary Reserve Ratio (PRR) component, but the Lease Liability is added back up to the amount of the RUA.
Modeling of the Lease Standard adoption have led to the following impacts and analysis.
- In most cases the LL will be equal to or higher than the RUA, so the impact on the PRR should be immaterial.
- The increase in total assets due to the RUA can move the ER by an amount of 0.2 to 0.3, and the impact is greater when the CSR isn’t maximized or close to being maximized.
- Institutions should consider the impact of a Tenant Improvement Allowance (TIA) and when the receipt of this will occur. A TIA provides benefit to the lease in that it lowers cost of any leasehold improvements. However, the result in the CSR is now having PPE which isn’t offset by long-term debt, resulting in a detriment in the PRR. Institutions may want to consider negotiating lower rent and funding all leasehold improvements with long-term debt. The long-term debt will be an add-back to the PPE incurred. The other option is to have the landlord pay for all leasehold improvements and having higher rent. In this case, the RUA and LL will each be higher, but the LL will offset the RUA in the PRR.
Implementing the Lease Standard for institutions has one other caveat that must be considered. In the Borrower Defense to Repayment Regulations (BDTR), which became effective July 1, 2020, ED defined the concept of pre- and post-implementation leases. This concept was included in the regulations as a transition period for institutions since the Lease Standard became effective for public entities on December 15, 2018, and most leases signed by an institution were not done contemplating the Lease Standard’s impact. Therefore, ED allowed some leases to be “grandfathered” as pre-implementation leases, while others were deemed to be post-implementation leases. The demarcation is that if the lease was signed, renewed or amended after December 15, 2018, the lease is deemed to be post-implementation and included in the CSR. If the lease has not changed since December 15, 2018, then the lease is deemed to be pre-implementation and is totally excluded from the CSR.
To assist with the implementation of these regulations, ED published a Financial Responsibility Question and Answers document on April 9, 2020. This document provided additional clarity and these specific answers.
- An institution can opt-out of the pre- and post-implementation treatment and treat all leases as post-implementation. The downside is that once an institution opts out, it is irrevocable (L-A2).
- If an institution enters into a change of ownership after July 1, 2020, all leases become post-implementation. The pre-implementation treatment was established to provide a safe harbor for reasonable business decisions which occurred before the Lease Standard effective date was known, and a change of ownership transaction is viewed by ED as a new business decision. Thus, the pre-implementation business decision is now tainted, and the option no longer allowed. (This is true even if the lease terms don’t change and the lease is merely assigned to the new owner) (L-A3).
- Institutions do have a one-time option to consider. If a lease is deemed pre-implementation, the lease has renewal options, and the institutions includes those renewal options in the RUA when the Lease Standard is adopted, the renewal options can be “locked in” as pre-implementation, even if the renewal date is after December 15, 2018. The value of the renewal options must be included in the RUA and LL calculations. This is a one-time option in the year the Lease Standard is adopted (L-A5).
As a side note, institutions should not forget about any possible impact on debt covenants for lenders and ratios for other regulators.
For all institutions, the adoption of this standard is within 12 months, depending on their year-end, so for December 31 schools, basically one quarter remains. If you haven’t started reviewing the impacts, it is time to start cramming for the test. Not planning for the impact could cause negative results in the CSR, audit delays and unnecessary stress for management. Time is still left, so don’t wait. The experts at McClintock & Associates are available to assist.