Recent History on Lease Guidance
The accounting treatment of leases has been a hot topic for more than a decade as standard setters and businesses attempt to comply with off-balance sheet reporting requirements addressed by the Sarbanes-Oxley Act.
To clarify how big this issue is: the SEC brings up the term “off balance sheet” 200 times in its “Final Rule: Disclosures in Management’s Discussion and Analysis about Off-Balance Sheet Arrangements and Aggregate Contractual Obligations,” and leases were among the first items considered as the SEC defined off-balance sheet arrangements.
Timeline and Primary Affected Party
Effective after the fiscal year Dec. 15, 2018 for certain entities including publicly traded companies, and Dec. 15, 2019 for private companies, the new lease accounting standard primarily affects the lessee. If any property, plant & equipment (PP&E) is leased the new standard will affect the company’s compliance and reporting requirements in that all leases will require a right of use asset and lease liability for the value of the minimum lease payments on that balance sheet.
For lessees: All leases will be classified as an operating or financing lease, with both being capitalized.
For lessors: All leases will be classified as an operating, direct financing, or sales type lease.
Things to Consider before Implementation
FASB is giving time for companies to plan the transition allowing entities to make “practical expedient” elections in connection to leases entered into before the new standard implementation date. With proper planning companies can coordinate their leasing arrangements and grandfather in certain leases, and therefore are not required to capitalize the ROU asset or lease liability. Without reinventing the wheel, there are articles written by Joe Sibek, CPA, outlining the new standards with examples for how companies can begin to navigate the transition. Instead below we look into other effects of the new leasing standards that may not yet be getting the full attention they deserve.
The potential for perhaps two or three trillion dollars in right of use assets and lease liabilities will be integrated into the financial markets where they will be reported, analyzed, valued and traded.
1. Changes will have an effect on the responsibilities of finance managers, investors and analysts.
For Example: When a company’s assets and liabilities increase, fundamental ratios such as the return on assets and debt to equity are affected. Furthermore, the treatment of lease elements in the financing section versus operating section of the cash flow statement will change trends that analysts and investors use to gauge a company, such as the quality of income ratio. Companies will need to communicate with their analysts to determine the effect the changes will have on their fundamental ratios and trading multiples.
2. Analysts will create entirely new ratios that have never been used before in the fundamental analysis and valuation of companies, especially those with material lease components.
For Example: According to the U.S. Equipment Finance Market Study, created by the Equipment Leasing & Financing Foundation “total public and private investment in equipment and software grew 4 percent in 2015, to $1.5 trillion” and “68 percent of the total value of equipment and software purchased in 2015 was acquired through the use of financing” and “of the 68 percent finance share, 39 percent was leased.” Breaking this down means well over $400 billion of annual lease payments are made for equipment and software, of which the present value over a few years quickly translates into trillions of dollars on a balance sheet.
The point is that fundamental ratios used to value and trade companies will be affected. Over time, trend lines will normalize and the companies most effective with their leasing strategies will show more quality ratios that will be taken into consideration by analysts and investors.
3. Companies will come up with personalized corporate finance strategies as they comply with the reporting changes in ways most favorable to their stakeholders.
For Example: Companies may change lease terms on certain assets to less than one year to keep those assets from being capitalized. Or companies may enter into long term lease arrangements before the standard goes into effect, and then elect the practical expedient, which allows them to treat the lease in the same manner as before the new standard. The manner in which lease components can be stripped out will vary from contract to contract, company to company and industry to industry, but those organizations who respond most effectively and efficiently to the changes will be best able to capture the value that can be created, or lost before the standard is implemented.
Imagine before the new lease standard a company’s balance sheet has $100 in assets, $50 in liabilities and $50 in equity, and that company is currently earning $200 annually, the ROA is 200 percent. The standard goes into effect and the company leases buildings with a minimum lease liability of $50, creating an equal $50 right of use asset. The new assets on the balance sheet total $150 with $100 in liabilities and $50 in equity. Assuming the company earns the same $200 the new ROA is 133 percent, or 77 percent less than the prior year. This is an extreme example, but the fact is that in a game of inches - or should we say percentages - every point is valued and what was once a normal fundamental ratio may not be so normal anymore as companies enter new leasing strategies.
4. Information and financial technology systems will be improved, updated or entirely created to service the large amounts of financial data that will come into the financial reporting requirements.
For Example: There are entire systems designed to work around the current financial reporting requirements and the slightest change to those figures will affect the output. SAP, QuickBooks and other record keeping, or financial processing software will require lease integration that can establish portfolio categories capable of monitoring, tracking and reporting each component of a lease. Assistant Controller with General Motors Brian Leiter, was recently quoted at the AICPA annual conference on SEC and PCAOB developments saying “a company’s information technology personnel will prove to be critical participants because they must judge if the new hardware or software is needed to meet the standard.”
5. The projected intrinsic value of a company may change.
For example: When performing a fundamental analysis and valuation of any stock using the Enterprise Value to EBITDA approach, a slight change in the debt as a percentage of assets results in a slight change of the projected valuation. How will these changes across all companies and industries impact their valuation, and how will the market forces respond?
It may be necessary for analysts and investors to create systems capable of stripping out lease components in their first year over year comparison, as the shock to the valuation may be grave. Over time expect more efficient markets as such a large component of the economy and a company’s financial performance will be more transparent for all users of financial statements.
Continue the discussion on lease accounting at Bloomberg BNA Accounting LinkedIn.
By Joseph Bailey, CPA
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