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Financial institutions should review FASB’s new ASU 2016-02 to prepare their entities and those they serve for changes to balance sheets and lease accounting guidance.

Regulations

New FASB Rule Challenges Financial Institutions and Loan Customers

  • Scott Lively
  • 9/22/2016

On February 25, 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2016-02 (Topic 842) announcing dramatic changes to accounting for leases. The ASU was collaborated by FASB and the International Accounting Standards Board (IASB) to improve consistency in financial reporting.

The new guidance aligns with financial statement users’ request for more information on an entity’s leasing activities, and will end the off-balance sheet treatment and require more disclosures.

The ASU will be effective the first quarter of fiscal years beginning after December 15, 2018, for public business entities. For all other entities, the effective date is for fiscal years beginning after December 15, 2019. Both preparers and users of financial statements are affected by these updated standards, so financial institutions should evaluate their current leases under this new guidance, and understand the requirements to help the people they serve navigate these changes.

Increased transparency in lease accounting

Let’s first understand the reason for the change. Over a decade ago, the U.S. Securities and Exchange Commission (SEC) issued a report that recommended changes to transparency in lease accounting. Soon after, FASB and IASB began addressing these proposed changes. The current accounting treatment of operating leases is one of the most significant uses of off-balance sheet accounting. The new guidance aligns with financial statement users’ request for more information on an entity’s leasing activities, and will end the off-balance sheet treatment and require more disclosures.

Right-of-use assets may affect lessee financial statements

Both preparers and users of financial statements will need to become accustomed to new terminology. The term “right-of-use asset” is used to describe the new asset arising from a lessee’s right to use an underlying asset for the lease term. The lessee will also see a related lease liability on their balance sheet, and how the off-balance sheet is eliminated.

More than 10 years ago, a report was prepared by the SEC on off-balance sheet activities that estimated that there is $1.25 trillion off-balance sheet operating lease commitments for SEC registrants. As we move to posting operating leases to the lessee’s balance sheets, the significance of the dollar amount that will be posted to the right-of-use asset and lease liability can substantially change the lessee’s financial statements.

Financial institutions and loan customers may adjust loan covenants

Financial institutions will need to become familiar with the ASU’s impact to loan customers and related loan covenants. For a loan customer that currently has significant operating leases that are off-balance sheet, the financial ratios utilized for loan covenants could be out of compliance under the new guidance. Some of the ratios commonly used in loan covenants are:

  • Debt-to-equity ratio: The formula for debt-to-equity ratio is total liabilities divided by equity. As an entity posts the related lease liability for the new guidance, the increase in liabilities will also increase the debt-to-equity ratio. Financial institutions rely on debt-to-equity ratio to monitor an entity’s leveraging of debt.
  • Earnings before interest, taxes, depreciation and amortization (EBITDA): This calculation may remain unchanged because the right-of-use asset will affect amortization expense, and the interest portion of the lease liability will affect interest expense. Even though the components of the EBITDA calculation will change, the final result should remain the same. 
  • Fixed-charge coverage ratio: The fixed-charge coverage ratio is used by lenders to evaluate the amount of cash flow available for debt service. This formula includes fixed charges such as interest expense, and the entity will need to determine the significance of the impact to the ratio.

The lease rule change does not appear to have a significant impact for community financial institutions, since a majority of these institutions do not engage in significant leasing activities. However, management will need to assess the impact on ratios for financial institutions with significant leasing activities.

Evaluate upcoming lease contracts prior to signing

Institutions will need to assess future contracts and other arrangements to determine if the agreement meets the new ASU’s definition of a lease. Moving forward, they will need to monitor regulatory guidance on treatment of the right-to-use asset accordingly.

Both financial institutions and the people they serve will need to evaluate lease renewals. By becoming familiar with the impact of the new standard before agreeing to new leasing terms, the entity will be able to make informed management decisions to help maintain compliance with the new guidance.

Lessees required to recognize assets and liabilities

The lessor accounting treatment is mainly unchanged from previous guidance, but some modifications were made to align with lessee accounting changes and revenue recognition guidance. For example, a lessee must recognize assets and liabilities for qualifying leases with lease terms of more than 12 months.

For finance leases under the new ASU, a lessee must:

  • Recognize a right-of-use asset and a lease liability, initially measured at the present value of the lease payments, in the statement of financial position
  • Recognize interest on the lease liability separately from amortization of the right-of-use asset in the statement of comprehensive income
  • Classify repayments of the principal portion of the lease liability in financing activities, as well as for payments of interest on the lease liability and variable lease payments for operating activities in the statement of cash flows

For operating leases, a lessee must:

  • Recognize a right-of-use asset and a lease liability, initially measured at the present value of the lease payments, in the statement of financial position
  • Recognize a single lease cost, calculated so that the cost of the lease is allocated over the lease term on a generally straight-line basis
  • Classify all cash payments within operating activities in the statement of cash flows

Disclosures will be expanded to assist financial statements users to assess the amount, timing, and uncertainty of cash flows arising from leases. Both qualitative and quantitative disclosures will be utilized to fully describe the entity’s leasing activities.

How we can help

While we have over two years to prepare for these new lease rules, financial institutions should begin reviewing the impending changes to help those they serve avoid unwanted surprises down the road. Loan customers with significant leasing activities will need to assess the impact to their financial statements and work with their financial institutions to remain in compliance with loan covenants.

By becoming familiar with this new guidance, financial institutions can remain compliant, gauge the impact to their current leases, and help their people make informed decisions as they evaluate new leasing terms.