The on- and off-balance sheet impact of FASB’s leasing project
CONSTRUCTION QUARTERLY UPDATES |
Most of you reading this are probably aware of the Financial Accounting Standards Board's (FASB) joint project with the International Accounting Standards Board on accounting for leases. The FASB's goal for this proposed guidance is to provide a financial statement reader with a more accurate presentation of the assets an entity has the right to use and obligations the entity must pay to use those assets.
The purpose of this article isn't to go over every aspect of the exposure draft in detail, but to provide a summary of the more common issues facing construction companies as lessees, and the impact of these leases on their financial statements and other financially driven documents. With an anticipated effective date of 2017 or 2018, and no grandfathering clause for existing leases, there is still time for management to evaluate and make changes to minimize the impact of these rules.
sing the new guidance, lessees will generally recognize a right-to-use asset and a lease liability at inception. This is quite different from today where the majority of leases are classified as off-balance sheet operating leases with no impact on the balance sheet.
The subsequent accounting is dependent on the classification of the lease. The proposed guidance classifies a lease as either Type A or B based on whether the lessee is expected to consume more than an insignificant portion of the economic benefits embedded in the underlying asset over the lease term. If so, the lease is classified as Type A; if not, it is classified as Type B.
For Type A leases, the lease liability is accreted through the recognition of interest expense and is reduced through lease payments. The leased asset is amortized over the lesser of the term of the lease or the useful economic life of the asset. The rate of amortization is based on a rational methodology similar to depreciating a piece of property or equipment.
For Type B leases, the lease liability is again accreted through the recognition of interest expense and is reduced through payments. The leased asset is also amortized over the lesser of the term of the lease or the useful economic life of the asset — however, the rate of amortization is not based on a rational methodology. Instead, the rate of amortization is the amount required to produce an even rent expense over the term of the lease. This results in an impact on the income statement similar to that of current operating leases.
In both cases, rent expense is a combination of the interest cost for the accreting liability and the amortization of the leased asset.
The difference in these two income statement outcomes can be shown best via the graph below where the vertical axis is rent expense and the horizontal axis is time:
As you can see Type A leases result in a higher rent expense in the early years of the lease which gradually lowers over time. So assuming all other factors equal, a Type A classification would result in lower net income in earlier periods than a Type B lease.
So what does all this mean for construction companies? In general, more lease liabilities will be recorded on company balance sheets which will increase debt-to-equity ratios. Also, for most companies, a key financial metric is either net income or earnings before interest, taxes, depreciation and amortization (EBITDA). As stated above, net income and EBITDA can vary depending on the type of lease. Type A leases will result in reduced net income amounts in the earlier years of the lease term and more income later than Type B leases. EBITDA is affected by the classification of the rent expense components. Specifically, rent expense is reflected as interest and amortization, both of which are add backs when calculating EBITDA from earnings. Under current U.S. generally accepted accounting principles (GAAP), only interest and amortization (not lease expense) are considered appropriate add backs so under the proposed guidance, EBITDA would be higher unless this metric is adjusted to address the change in rent expense.
Based on this, below are areas we encourage management and owner to review:
- Lease versus buy scenarios. While this is likely impractical for facilities, it is something to consider when leasing equipment and vehicles.
- Compensation and consulting agreements where employees or consultants are paid based on the net income or EBITDA of the company.
- Business acquisition earn-out agreements that have hurdles based on the future net income or EBITDA of the company.
- Agreements with financial covenants based on net income, EBITDA and debt-to-equity ratios.
- Related party lease agreements — if the company is leasing a facility from a related-party entity, it may be preferable to consolidate the entity, rather than show the grossed up impact of the lease on the balance sheet.
- Succession planning, including the potential sale of a business, as lease liabilities may be treated as debt-like instruments that could result in reduce proceeds to the seller.
Our advice for today is to take the time to consider the implications this standard may have on your business and evaluate the costs and benefits of addressing these implications now or later. Most importantly, we believe having an understanding of how this proposed guidance will impact the company's financial statements and agreements can help management and stockholders determine the best course of action to meet the future.