MCG Spotlight – A Conversation on Lease Accounting
In this edition of MCG Spotlight, Paul Greilich sits down with Jeff Weinberg, Zak Everson, and Paul Dunn to discuss the new lease accounting standards and what they mean for you and your business.
Paul Greilich: Well hello, everyone, and welcome to this edition of Spotlight. My name is Paul Greilich and we’re here today to talk about the new lease accounting standard.
I’ve got with me Paul Dunn, Zak Everson, and Jeff Weinberg with Montgomery Coscia Greilich here so let’s jump right into it.
Paul Greilich: Zak, what are some of the major changes companies are going to have to deal with in terms of this new lease accounting standard?
Zak Everson: Clear-cut, all leases are going on the balance sheet. There will no longer be a differentiation between capital and operating. All leases will be recognized on the balance sheet as an asset and a related obligation. Historically, you’ve performed a test to see if a lease would be recognized on the balance sheet or off the balance sheet, so that’s gone. You will still perform somewhat of a similar type test to classify the lease, but that really dictates P&L treatment of the of the related lease payments. At the end of the day, we’re going to have an asset on the balance sheet, we’re going to have an obligation on the balance sheet for every lease that exceeds 12 months. So, some month-to-month or short-term leases will continue to just be period cost as payments are made, but any assets that we lease and use in our organizations will be recognized as an asset and a related obligation
Paul Greilich: Okay, future minimum payments of leases will be capitalized.
Jeff, how will those calculations be done? Will it be much different than what we’ve done before?
Jeff Weinberg: Well, as Zak indicated regarding recognizing the right of use asset and liability, and as you noted, we’ll use the present value minimum lease payments to do so for new leases. You’ll still go through a bit of analysis, as Zak indicated, in terms of whether something is an operating or finance lease. But, because operating leases greater than 12 months certainly will go on the balance sheet, they will be recorded very similarly in a general sense.
Paul Greilich: So, any changes in what’s to be considered minimum lease payments? Contingent rents got talked about a lot, where did the FASB wind up on that?
Jeff Weinberg: In many cases, there are similarities. In terms of the contingent rent specifically, especially when you look at percentage rents, something that’s not based on an index, for example, you would not include that in minimum lease payments. If it’s an index, such as an escalation, you would still include that. So again, similarities. I think when you even consider structuring leases now, one of the things that has come up is, if you’re economically basically in the same place and achieved your objectives, is there an opportunity to perhaps have even more incremental percentage rent if you are under a percentage rent lease and retail, for example, versus your base rent. Again, that will be a period expense and not included in minimum lease payments.
Paul Greilich: Okay. So, what are what are the impacts to the income statement and the cash flow?
Jeff Weinberg: Well, in terms of the income statement, I think the important point here that you both illustrated, is that the FASB wanted to have leases on the balance sheet for transparency and historical reasons for readers of financial statements being able to more clearly understand the financial picture for companies. To the income statement, you will still end up with a rent expense and the FASB in constructing this, did not necessarily want to alter the current financial reporting of these leases other than to get them onto the balance sheet. So, in terms of the actual rent expense calculation you will actually have amortization schedules that you will use for the new operating leases on the balance sheet. You will still end up recognizing straight-line rent, but in essence you will have an interest and amortization component and really all that will be done is you subtract your interest from your straight-line rent and that’s your amortization. On the income statement this does still get categorized as rent, not effecting EBITDA.
Paul Greilich: This is a big change. All lease payments are going on the balance sheet. There’s a number of companies that have hundreds of leases to deal with. Will they have to go back and reassess all the leases that they currently have?
Zak Everson: Existing leases that were capital will remain capital, existing leases that were operating will remain operating, as far as the analysis goes under the new standard. As Jeff said, new leases that come online after the standard is implemented will be subject to the new analysis.
Paul Greilch: Okay, all right. So still a big change. Seems like there’s a lot of accounting to do, right? Calculating what the obligations are going to be, assessing what the impact is. Paul, what have some of your clients been going through to get their arms around this?
Paul Dunn: Well it’s a significant impact. It’s a significant impact from a financial reporting standpoint. The issue here is that this standard has been deferred and deferred and now it’s being implemented. Now, the FASB is saying the time is now to act and I think a lot of finance organizations have been assuming that it may be deferred once again, but that’s not going to happen. Now, a lot of finance organizations are finding that they’ve got to mobilize very quickly in order to implement this new standard and unfortunately, they find themselves under-resourced in order to react. The reason being is that some organizations have literally hundreds of lease agreements that may be spread throughout the organization. If you think about it, who maintains those lease agreements? It may be the business unit leader, it may be operations, it may be the legal organization. It’s not always the accounting organization. The accounting organization only reports the results of the lease agreement and so now the accounting organization has to get their arms around what’s in those lease agreements and they may be maintained and controlled by the legal organization or the operations organization. It creates a lot of complexity and implementation.
Paul Greilich: So, have companies underestimated how to assess how many leases they have and how many areas of the company that this could impact, Jeff?
Jeff Weinberg: Certainly, even if you have a small number of leases and you’re going through implementation, that can still cause problems. What will happen is, as Paul indicated, you could have an office lease, for example, that has been amended three or four times and trying to find amendment number two to confirm what your original lease payments were, have you recorded them, what your future lease payments are to actually record the new asset and liability. Really, what we’ve seen is if you have a large number of leases it may recast the decision of how you manage those. So, if you’re getting past 50 leases or if you’re growing to a point of getting close to that number or you will soon, that may be a sign – hey I need to actually use lease administration software to do these calculations and manage other critical dates and things.
Paul Greilich: So, Zak, what are some questions you’re getting from your clients in terms of – hey is this going to impact my banking relationships, covenants? What are some concerns that you’ve been hearing?
Zak Everson: Sure. From the client side it’s all over the place. Will my lender allow me to continue under old GAAP, or not? Will I have to go through an amendment? And, what we’re seeing on the lending side is a mixture. Some lenders are well ahead of it internally knowing that they’re going to have to amend certain loan agreements to comply with covenants that were agreed to well before the standard took place. Some lenders are just going to roll with it and the companies are going to have to just meet covenants as they are. We’re seeing that all over the place. I don’t think there’s consistency on that yet, but clients are well aware of it and should be proactively having these discussions with their lenders or other stakeholders about how their certain covenants ratios things like that will be impacted, because they certainly will be.
Paul Greilich: So, Jeff, I’m curious about how the markets are going to react to this new standard and how it’s going to impact financial statements and valuations. What are you hearing out there?
Jeff Weinberg: The big question, of course, and we’ve kind of danced around it, is what’s going to happen to EBITDA. Although there is some question, for the most part technically, EBITDA won’t change. From that perspective, again if you’re an operating lease, it’s not going on the balance sheet, you’re still going to have rent expense. Of course, the components underlying that are the interest and amortization, but for the income statement that will not affect EBITDA, per se. Certainly it gets treated differently in the cash flow statement where you have an add back for depreciation, but those components stay the same for that purpose. Clearly, this process and including many more enhanced disclosures, readers the financial statements now will have an even better idea of what the balance sheet looks like, the level of leverage. In many cases, credit rating agencies, for example, for state tax purposes have been imputing what this number looked like, but now you’re actually going to see it. So, certainly, there will be some kind of reaction to that once that gets enforced.
Paul Greilich: In terms of new leases, though, when evaluating a new lease, a lot of times when applying the 90% tests or the useful life test, things are right on the line depending on what discount rates you use. Historically, companies, it seems, haven’t wanted to put them on their balance sheet and would just rather they be operating leases. They didn’t want to have to do the accounting. Probably the overhead and the burden of it all, I’m sure. But now, with it all going on the balance sheet and having to go through the calculation, I’m curious if they’re going to lean toward pushing them to be capital leases, because then the classification of interest expense and depreciation turn into add backs for EBITDA purposes. So, I’m curious if some of those structuring ideas have been kicked around with some of your clients.
Jeff Weinberg: It definitely it could be the law of unintended consequences, to some extent. I think there are going to be structuring opportunities like that. Again, when you look at if you’re economically more indifferent, then that does give you that capability. Even within the leases themselves, one of the things that’s really important here in terms of the new lease guidance is what is the definition of a lease. Now, we have a situation where, in totality, when you look at all the different pressure points of the new guidance, clearly you could have agreements that maybe haven’t historically been leases and now those arrangements, because they meet certain criteria like a supplier arrangement for example, could actually be a lease and apply to the guidance. So, again, you definitely have different areas where you can structure accordingly depending on what your goals are.
Paul Greilich: Well, thank you, everyone. We appreciate the time today. Obviously, big changes for the accounting and finance world, but more to come.