By Michael T. Wherry, CPA, Director/Shareholder and Ted Blendermann, CPA Director/Shareholder, McClintock & Associates, PC
Remember in the movie the Perfect Storm, how three independent storms collided to create disaster for the Andrea Gail fishing ship. Similarly, with the Financial Accounting Standards Board’s (FASB) issuance of Accounting Standard Update 2016-02 (ASU), Topic 842 – Leases, the FASB has created a potential composite score disaster scenario for many schools.
Some background first. FASB is the oversight board for accounting standards relevant to entities who issue reports in the United States of America. The FASB and the International Accounting Standards Board (IASB) undertook a project in 2006 to converge Generally Accepted Accounting Principles in the United States of America (GAAP) and International Financial Reporting Standards (IFRS). The goal was to eliminate the differences between GAAP and IFRS so financial statements in a global economy would be comparable. One of the more significant accounting pronouncements to converge was the treatment of operating leases. Under GAAP, operating leases were expensed in the period the asset was utilized, and no liability was reflected on the balance sheet. The commitment was only disclosed in the footnotes to the financial statements. Under IFRS, operating leases were reflected as an asset and liability on the balance sheet and, thus, comparability between entities was difficult especially for industries such as the airlines which have numerous long-term operating leases for airplanes.
ASU 2016-02 will change the accounting treatment of leases for entities which issue GAAP basis financial statements and is effective for public entities with fiscal years beginning after Dec. 15, 2018 and for non-public entities with fiscal years beginning after Dec. 15, 2019. The focus of this article is how the ASU affects specifically a postsecondary institution as the lessee.
The most significant impacts as a result of the ASU are the following:
- Recognition of leased assets and liabilities on the balance sheet,
- Treatment of related party leases, and
- Effect on regulatory ratios and debt covenants.
The most critical impact of this new ASU for postsecondary institutions will be on ED’s composite score ratio and debt covenants to a lesser extent.
Thus, institutions need to understand the impact now to begin the process of identifying and implementing solutions. In order to understand this impact, let’s review the basics of the new lease standard.
Prior to the issuance of the ASU, lease classification determined not only how lease expense was recorded in the income statement, but also whether the institution was required to record an asset and a liability associated with the obligation under the lease. A lease was classified as either an operating lease or a capital lease, and classification was based on a number of criteria, including specific bright lines and numerous interpretations. Under an operating lease, recognition of the underlying asset and associated lease liability on the balance sheet was not required, and rent expense was recognized on a straight-line basis over the lease term on the income statement. Conversely, a capital lease required the institution to reflect an asset and corresponding lease liability equal to the present value of the future lease payments on the balance sheet, and depreciation expense and interest expense was recognized on the income statement.
Under the ASU, virtually all leases will require balance sheet recognition as a right-of-use asset and lease liability. However, lease classification will impact the amount and timing of lease expense.
The new lease standard has a number of components to assess from an accounting standpoint including: identifying the asset, control of the asset, right to direct the use of the asset lease, lease and non-lease components, and the lease term including renewal, termination and purchase options. These items won’t be discussed in detail as this article is focusing on the broader impact and the regulatory effect of the standard.
Under the ASU, any operating lease with a length of 12 months or longer must be recognized on the balance sheet. An institution will recognize a “right-to-use” asset and a “lease liability.” The institution will need to review each lease and determine if the lease is a finance or an operating lease. Finance leases are leases in which the institution will lease the property for the majority of its useful life or ownership transfers at the end of the lease from lessor to lessee. This would most likely occur for equipment leases (copiers, vehicles, etc.). Operating leases are leases in which the institution will not lease the property for the majority of its useful life or retain ownership at the end of the lease. This would most likely occur for real estate leases (i.e., buildings). (No specific “bright line test” exists to distinguish between finance and operating leases but the standard does provide guidance for consideration). The recognition of the lease on the balance sheet is virtually the same for finance and operating leases. The main difference is the recognition of the expense on the income statement. Finance leases will recognize amortization expense on the right-to-use asset and interest expense on the lease liability. As such, the lease expense cost is similar to the existing capital lease accounting standards. Operating leases will recognize the expense in one line item called lease expense which will be the same over the lease life. The total expense recognized over the entire length of the lease will be the same for finance and operating leases.
In order to recognize the right-to-use asset and the lease liability on the balance sheet at the lease inception, an institution will need to compute the present value of the future lease payments at the time of the lease commencement. The fair value is computed using the rate implicit in the lease or the institution’s incremental borrowing rate. (Nonpublic entities can use a risk-free rate; however, this is considered a policy election and must be utilized consistently for all leases). This present value of future cash flows is the amount of the right-to-use asset and lease liability which will need to be recorded. Other factors do exist which need to be considered such as executory costs, lease options, variable lease costs, etc. and these items will need to be reviewed on a lease by lease basis. However, for planning purposes and projection of the impact on your institution, the present value of the future cash flows should provide a materially correct number.
As you can see, while the institution’s commitments haven’t changed, under the ASU an operating lease will result in the balance sheet reflecting higher assets and higher liabilities.
The effect on equity is minimal as the amount of expense will be similar under the current standards.
While the accounting is relatively straight-forward for leases from unrelated third-party entities, for many small nonpublic entities, the lease of the institution’s building is from a related party. For tax planning, frequently the institution’s leased real estate is maintained in a separate entity from the institution. In these situations, the lease of the real estate may or may not have a formal agreement. In addition, a one year lease agreement may exist, and this lease agreement is renewed on an annual basis. In these situations, management usually has control of the real estate being leased which raises questions as to the actual long-term commitment which is in existence.
As discussed above, the length of the lease is critical in determining the present value of the future cash flows needed to recognize the right-to-use asset and lease liability.
Thus questions arise such as:
- What if no formal lease agreement exists?
- What if the lease renews annually for only a one year period of time?
- Does the length of the time the institution has already utilized the real estate have any bearing on the future commitments and right-to-use which needs to be recognized?
- What is a reasonable lease life?
Applying some of the standards of the ASU is subject to facts and circumstances and, unfortunately, the ASU provides very little guidance as to how related party leases should be treated. Leases between related parties should be classified in accordance with the lease classification criteria applicable to all other leases on the basis of the legally enforceable terms and conditions of the lease. Consideration should be given to whether significant economic interests to renew exist and that qualitative and not just quantitative aspects must be considered. Some non-authoritative guidance indicates that this is the case even when related-party transactions are not documented and/or terms and conditions are not at arm’s length. Other non-authoritative guidance implies that lessors and lessees must account for related party leases based upon legally enforceable terms and conditions of the lease. Thus, many related party leases could potentially be excluded from the lease standard as they might not constitute enforceable contracts. This approach would eliminate the current GAAP requirement to evaluate the economic substance of the arrangement, and related party leases would only be disclosed rather than recognized. We are hoping that the FASB understands the uncertainty this ASU has caused for related party leases and that additional guidance will be forthcoming.
With the high-level background of the standard on an institution’s financial statements established, we can review the impact on the institution. As a quick review, ED’s composite score ratio has three components: Primary Reserve Ratio, Equity Ratio and Net Income Ratio. See the Appendix A to Subpart L of Part 668 – Ratio Methodology for Proprietary Institutions. (The impact for private nonprofit institutions is similar and is found at Appendix B Subpart L of Part 668 – Ratio Methodology for Private Non-Profit Institutions). As discussed earlier, the overall effect on the expenses and net income should be minor and thus minimal changes to “Total Expenses” and “Income before Taxes” will occur. (The ASU has no effect on Total Revenues unless the institution is also a lessor of property and that impact is not discussed in this article). The recognition of the right-to-use asset and lease liability impacts the Primary Reserve Ratio and the Equity Ratio.
The numerator in the Primary Reserve Ratio begins with total equity and is then adjusted for specific items to obtain adjusted equity. One of the adjustments is the subtraction of the net property, plant and equipment balance. Another is that long-term debt is allowed to be added-back up to the amount of the net property, plant and equipment balance which was subtracted. In addition, intangible assets are subtracted from equity and no corresponding add-back exists for these assets. Intangible assets are items such as trademark, goodwill, etc. These normally occur in a business combination transaction when a buyer acquires another institution for a price in excess of the fair value and this excess purchase price is an intangible asset. The ASU doesn’t define the right-to-use asset as an intangible asset. However, during our firms’ attendance at a state society accounting and auditing update session in December 2016, the presenter indicated the right-to-use asset was an intangible asset. In addition, the presenter communicated that the lease liability is not considered long-term debt which is consistent with the rational that the right-to-use asset is an intangible asset and not property, plant or equipment. The treatment of the right-to-use asset as an intangible asset creates a significant negative adjustment to the Primary Reserve Ratio’s numerator.
Therefore, the most draconian outcome of the ASU could be a reduction in the Primary Reserve Ratio numerator by the amount of the right-to-use asset with no related add back for the lease liability.
The second effect on the composite score ratio is the impact on the Equity Ratio. This ratio utilizes total equity as the numerator and total assets as the denominator. These are then reduced for a couple of specific items one of which is intangible assets to obtain modified equity and modified assets. If the right-to-use asset is treated as an intangible asset, equity will be significantly decreased by the intangible asset subtraction which will have a detrimental effect on the composite score ratio.
If the right-to-use asset is not deemed to be either property, plant or equipment, or an intangible asset, in ED’s composite score ratio, there is still an impact on the Equity Ratio as total assets of the institution will increase as a result of the recognition of the right-to-use asset. While this impact would seem to be small, we believe the effects could be more detrimental than many institutions currently realize. Depending on the length of an institution’s leases, the right-to-use asset could be a significant asset which will be recognized on the balance sheet. We are beginning to project preliminary composite score ratios using the most recently issued audited financial statements and assuming the ASU was effective as of the most recently issued audited financial statements.
If the lease lives range from five to 10 years, the impact on the composite score ratio solely as a result of the increase in the total assets in the Equity Ratio can negatively impact the score by 0.5 for the handful of calculations we have performed.
Thus an institution with a current composite ratio score of 2.2 would be a 1.7 when the ASU is effective assuming all else being the same.
ED has received an “accounting windfall” from the FASB as a result of the ASU especially considering this ASU was not even on the FASB’s radar when the composite score ratios were created in the 1990s. In our opinion, we believe that the right-to-use asset is not the same as an intangible asset such as a trademark or goodwill. The right-to-use asset under the ASU is for a specifically defined physical asset (i.e., equipment or real estate) and these were not the types of intangibles which ED was considering when the composite score ratio was originally developed. As a comparison, under current GAAP, for a capital lease which recognizes the asset and liability on the books of an institution, ED treats the asset as property, plant and equipment, and the liability as debt in the composite score. Thus the ASU will potentially change this treatment in ED’s composite score ratio calculations. At this point in time, ED has not made any announcement as to how the impact of this ASU should be treated in the composite score ratios. From past conversations, ED has communicated that the composite ratio score will follow (GAAP). Thus, in our opinion, the determination of the right-to-use asset classification is critical. Even if ED is silent as to whether the right-to-use asset must be treated as an intangible asset in the composite score ratio and issues no specific guidance, the Equity Ratio will be affected by, at a minimum, the increase in total assets due to the right-to-use asset.
This ASU will also impact debt covenants contained in credit agreements due to the increase in total liabilities and the requirement to reflect a current portion of the lease liability. (This could also affect current ratio levels and ED’s opening balance sheet acid test requirement). In addition, for finance leases the reclassification of lease expenses as amortization and interest expense will change Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) which is a benchmark used in many debt covenants and as a multiple for valuing an institution during a sales transaction. We believe that the risk is lower in regard to debt covenants as bankers with whom we have relationships are aware of these regulations and are in the process of discussing either amendments to their debt covenants or the use of a “frozen-GAAP” clause which would eliminate the effects of ASU on the debt covenants. Thus while this is still an important issue, we feel that it is less critical than the effect on ED’s composite score ratio.
What next? Based upon the ASU’s implementation effective date, management needs to utilize 2017 to determine the impact on their institution and to begin to develop solutions. Steps which management should consider taking include the following.
- Compile a complete list of all lease agreements of the institution and ensure the lease agreements are available.
- Model the effects of the ASU on your institution’s financial statements. Consider if you want to use the risk-free rate, or utilize the incremental borrowing rate/rate implicit in the lease. While the risk-free rate is simpler, this rate will normally be lower than the incremental borrowing rate/rate implicit in the lease and thus using a risk-free rate will yield a larger right-to-use asset and lease liability amount. Engaged your external auditor to assist with these calculations, if necessary.
- Depending on each institution’s specific circumstances, determine if folding the related party real estate institution into the institution is feasible. Tax and insurance liability factors must be considered as well. This solution doesn’t prevent the increase in total assets but it ensures the real estate and the mortgage will be treated as property, plant and equipment, and long-term debt, respectively, in ED’s composite score ratio calculation so the Primary Reserve Ratio and the Equity Ratio are not potentially negatively affected by the intangible asset subtraction. This solution may be more beneficial in the future, if and when, ED issues any guidance as the treatment of the right-to-use asset as property, plant and equipment or an intangible asset.
- Consider if real estate leases can be shortened with additional renewal options? For example instead of 15-year lease, structure as a five-year lease with two five-year renewal options. Renewal options need to be considered at the time of the lease commencement as to whether it is likely they will be exercised so they can’t be completely ignored. However, this may enable an institution to initially recognize a five-year lease and then in year four recognize the first five-year renewal option and then the second five-year option in the future.
- Network and share the impact of the ASU on your composite score ratio with sector peers and colleagues. The impact on the entire postsecondary sector needs to be communicated to ED in a coordinated manner. Discussions with ED need to occur now, so ED has time to evaluate and understand the effects of the ASU in order to issue composite score ratio guidance.
In our opinion and we could be wrong, we don’t believe ED’s original intention was to fail a large majority of institutions due to the composite score ratio. While we realize the environment today is much different than the 1990s, we don’t believe the issuance of the ASU should be the reason a significant number of institutions fail the composite score ratio when the underlying economic situation of the institution hasn’t changed. The composite score ratio intangible asset subtraction was based upon a specific set of accounting standards which existed in the 1990s and needs to be updated due to the changes in the accounting standards. However, it is the sector which needs to push ED for these changes and communicate the looming effects of the new lease standard.
Due to the new federal regulations which became effective over the past couple of years, institutions have had a significant amount of compliance issues to understand, develop compliance solutions, and determine their effect. As a result, we fear, the impact of this ASU has not been identified and evaluated at many institutions. Determining the impact now before new leases are signed and the ASU is effective, and communicating the impact to ED is a critical step.
MR. WHERRY is a Certified Public Accountant who has 25 years of experience providing a full range of client service and consulting services in the public sector to postsecondary schools which include financial statement audits, Title IV compliance audits, agreed-upon- procedure attestation engagements for regulatory requirements, 90/10 calculation reviews, composite score projections and planning, financial statement reporting consulting and understanding of new accounting requirements, transaction services for buyer/sellers, internal control processes and procedures, and coordination with Tax Department on tax savings and opportunities. He has presented at regional and national industry conferences in regard to regulatory and audit issues affecting postsecondary institutions.
Prior to joining McClintock & Associates in 1991, Mr. Wherry worked for Deloitte. In addition to his professional responsibilities, Mr. Wherry is the treasurer of the East Liberty Family Health Care Center in the city of Pittsburgh and has earned the honor of Eagle Scout. He resides in Pittsburgh, PA with his wife and two sons.
Contact Information: Michael T. Wherry, CPA // Director/Shareholder // McClintock & Associates, P.C. // 412-257-5980 // firstname.lastname@example.org // http://www.mcclintockcpa.com // https://www.linkedin.com/in/mike-wherry-a542259
MR. BLENDERMANN is a Certified Public Accountant who has over 30 years of experience providing a full range of client service and consulting services in the public sector to postsecondary schools which include financial statement audits, Title IV compliance audits, agreed-upon- procedure attestation engagements for regulatory requirements, 90/10 calculation reviews, composite score projections and planning, financial statement reporting consulting and understanding of new accounting requirements, transaction services for buyer/sellers, internal control processes and procedures, and coordination with Tax Department on tax savings and opportunities. Mr. Blendermann also has experience related to nonprofit entities and is responsible for the audit and attestation quality control process at McClintock & Associates.
Prior to joining McClintock & Associates in 1985, Mr. Blendermann worked for Deloitte. In addition to his professional responsibilities, Mr. Blendermann is a board member and treasurer of Del Ray Ministries. He resides in Pittsburgh, PA with his wife and daughter.
Contact Information: Ted Blendermann, CPA // Director/Shareholder // McClintock & Associates, P.C. // 412-257-5980 // email@example.com // http://www.mcclintockcpa.com // https://www.linkedin.com/in/ted-blendermann-607b675/