It’s All About Lessee-Side Balance Sheet Reporting
by Phil Tirino October 2016
With the new FASB lease accounting standard inching ever closer to implementation, CPA Phil Tirino takes a closer look at the new leasing guidelines and gives further insight into what needs to be done to prepare and some technical points of distinction for operating and finance leases.
Phil Tirino, CPA, PAMS-DCF, Inc.
The long anticipated FASB lease accounting standard (ASC 842) was released on February 25, 2016. The rules do not require implementation until years beginning on or after December 15, 2018 for public companies and December 15, 2019 for all non-publicly traded companies. The reasons for the seemingly long delay in implementation may include the need to allow companies time to absorb the ensuing introduction of lease debt into their balance sheets, even if separately classified. Companies should begin implementation for this reason alone, as soon as possible. Other reasons may be the sheer weight of the workload on existing resources, including staff and systems, time to overcome the learning curve and time to conceptualize and codify a plan of implementation. Two to three years may yet prove to be challenging considering the scope of the changes.
It is the intent of this article to present to the reader enough details to permit a management overview and assist in the development of a preliminary plan.
What Has Changed Under The New Rules?
All obligations relating to the use of hard assets, of whatever nature with rare exceptions, are required to be recorded as assets and liabilities on the balance sheets of the lessee. All transactions will require minimal present value analysis using suitably designed software or financial calculators. Regardless of lease classification, it is going on the balance sheet.
There remain only three categories of leases, the finance lease, the operating lease and the sales type lease. Sales type leases pertain to lessor reporting where a component of the transaction gives rise to a sales margin-over-cost profit. The balance of the lease is treated as a financing. Lessor accounting has remained essentially unchanged except for the loss of the leveraged-lease accounting model going forward. We will focus all of our attention on lessee side reporting for the two categories, the finance lease and the operating lease.
The rules require that any legally binding obligation for the use of tangible property, personal and real, extending beyond one year, be recorded as both a right-of-use asset (ROU) and legal liability in the lessee’s balance sheet using their present value amounts. The elimination of the time-value element contained within the stated liabilities is essential to make asset values comparable for analysis and credit purposes. It does not matter that the obligation is classified as an operating lease or a finance lease from a balance sheet standpoint. They are both recorded in the same amount no matter how the transaction is “cast” or interpreted. When rentals are discounted at the company’s marginal borrowing rate, the resulting number could be huge and may violate loan agreement covenants. ASC 842 was modified to require separate categories for operating and finance type leases to be shown on the balance sheet as lease liabilities. Removing them from the debt category has eliminated the risk of covenants being violated technically, but not so much in substance. The rules governing classification between an operating versus a finance lease essentially follow the old principals of effective transfer of ownership via legal, useful life or market value attributes. “Casting” means interpreting the elements to decide which category to assign the transaction to, operating or finance. The importance of casting is significantly reduced by the fact that it is going on the balance sheet no matter what.
What Should Management Consider Doing to Prep for this Project?
The idea that there may exist somewhere a nice neat listing of all leases that do not appear on the balance sheet will probably have a short life span. Expect that the discovery of equipment and real estate leases may turn out to be the most difficult part of the project. A central project leader might be considered. Some places to search may include how lessors are being paid and by whom. A listing questionnaire disseminated to key equipment users and real estate occupants may help. Request that accounting provide a listing of payments that may be considered recurring items. Examine property tax returns for equipment reported and investigate them. If there is a central control office or legal department that may have records, have them prepare a list of documents in their possession covering equipment and real estate leases. Try to have the control structure follow the equipment location as close as possible. This will permit the review of property tax records as part of the discovery process, bring organization to the process and provide a ready back trail.
Abstraction of Data
Once a comprehensive list of off-balance sheet equipment contracts is created, using a questionnaire, obtain the parameters of the ROU asset and the legal agreements where available. Return the information to the central coordinator for sorting and review with relevant documents attached.
Assembly, Review, Codification and Classification
Sorting and analyzing the returned information will require a person with a working knowledge of the pronouncement and some knowledge of discounted cash flow techniques. That person will have to decide based on his knowledge of the pronouncement, which lease classification to “cast” the transaction as, operating or finance. The decision process, once a contract codification of terms has been prepared, can be outsourced to your accounting firm, for example.
Some Key Technical Points to Consider
The lessee reporting requires all numbers be accumulated distinguishing between operating versus finance leases.
The Operating Leases
The ROU (right of use) asset balance is amortized under an operating lease by computing the total payments (gross cost), dividing that sum by the term giving the periodic amortization, and finally subtracting the interest element presumed to be contained in the payment. The P&L charge of the gross rent remains the same as current practice. The interest element is measured by the internal rate of return (IRR) amortization schedule (initially used to compute the present value) and is not reflected in the balance sheet ROU asset balance. There is a hybrid number created different from the IRR principal amortization and different from where we land for finance lease amortization. We have mixed simple straight-line computations with IRR computations. A process made necessary by the operating lease model using an average gross rent P&L charge inclusive of an interest element.
The Finance Leases
For finance lease purposes, the ROU asset balance is the same as the operating lease but is amortized using a straight-line amortization based on the net equipment cost in the P&L. Resulting ROU asset balances are slightly different from the operating lease and of course different from the IRR principal remaining from whence all these computations come. Interest is charged to the P&L per the IRR amortization schedule. So we have two slightly different ROU balances at any given point as between the operating lease and the finance lease after the start, and neither of the ROU balances are the same as the remaining principal of the loan at any given point. They do converge to be the same by the end of the term. The only number that remains true to present value numbers is the lease liability that is the same for both the operating lease and the finance lease and is the same as the IRR computation. It is the remaining principal.
As dictated by the above balance sheet treatment, the P&L is charged using a straight-line amortization of the gross rents paid as an operating lease. Casting or interpreting the same lease as a finance lease the P&L is charged using the straight-line amortization of the net cost (present value, not gross payback) and a separate interest expense is charged based on the loan amortization schedule. Hence, the finance method returns a front-ending of expense because of the interest factor on higher early term debt.
Is There a Simpler Way?
All the footwork remains to be done, but maybe the recording mechanics can be simplified somewhat. If you consider that instead of doing 1,000 separate discounted cash flows you could do only one by using the portfolio approach as alluded to in “Portfolio Exception” of ASC 842, you can appreciate the potential for saving considerable time and effort, while simultaneously bringing organization to the project. We could find very little detail on this aspect of recording transactions. Probably at this point there is very little available. We have done some modeling work treating a small number of transactions starting and ending at various dates as a single unit cash flow. Applying a marginal borrowing rate you can easily discount back the cash flow and continue as you would with a single transaction. There are numerous benefits besides a huge timesaving. One clear benefit is to smooth out the effects of adding in new transactions, resulting in a more evenly distributed P&L and balance sheet impact. A second benefit is organizational control. We immediately gain organization by putting the transactions into vintage categories. The portfolio approach could be used as a one-time catch up approach or as a continuing year-to-year “vintage” approach treating each year’s transactions as a separate unit or single deal. Many avenues remain to be explored and constraints on deal similarity remain to be defined. In fact, the entire topic is wide open.
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