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New Guidance Issued on Leasing Arrangements

This new lease guidance will have considerable accounting implications on financial statements. The new lease guidance also adds additional disclosures to the financial statements, so now is the time to begin evaluating the potential impact of this new leasing standard and working on adopting it as soon as possible.

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This new lease guidance will have considerable accounting implications on financial statements. The new lease guidance also adds additional disclosures to the financial statements, so now is the time to begin evaluating the potential impact of this new leasing standard and working on adopting it as soon as possible.

In February 2016, the Financial Accounting Standards Board (FASB) issued new guidance on accounting for leasing arrangements, which will bring with it a host of changes to accounting and financial reporting processes across many industries—including healthcare organizations—beginning in 2020.

The changes will impact those organizations that present their financial statements in accordance with U.S. Generally Accepted Accounting Principles (GAAP). Specifically, such organizations will have to recognize assets and related liabilities on their balance sheets for the vast majority of their leasing arrangements. Under current GAAP, operating leases are not required to be accounted for in this way, and rent payments are simply expensed to the income statement as incurred. Organizations should start considering the impact of the new lease guidance on their financial statements now.

Consider Your Leasing Arrangements

Generally speaking, all leases with a term greater than 12 months will need to be recognized in accordance with the new guidance. While some organizations have at-will leasing arrangements (i.e., no formal leasing agreement in place), the economic substance of the arrangement may need to be considered under the new guidance.

For example, if you lease your facility building under an at-will arrangement and it is new, recently refurbished, and/or is leased from a related party, the likelihood of abandonment in the near-term is low, and the realistic terms may need to be determined in order for the arrangement to be appropriately recorded on the balance sheet. As a result, now may be the time to formalize any at-will arrangements. The new guidance requires lessees and lessors to account for related-party leases on the basis of the legally enforceable terms and conditions of the lease and not on the basis of the economic substance of a lease. Further, if the organization will be entering into any new leases over the next few years, particularly with third parties, management may want to consider shorter-term leases in order to reduce the impact to the balance sheet.

Consider Creating a Lease Inventory

It is important to begin preparing an inventory of your leasing arrangements, gathering all the related lease documents and creating a summary of the significant terms such as payment amounts, lease term, extension options and likelihood of extension. Recording the lease transactions under the new standard can be quite tedious, especially as the number of leases increases. Preparing such an inventory now will allow you to begin a dialogue about the implementation of the guidance with both your internal and external accounting teams. Additionally, one important note is the change in definition of what constitutes a lease under the new accounting standard.

Consider the Impact on Financial Covenants and Working Capital

Since implementation of the new guidance will increase the overall liabilities reported on the balance sheet (the lease liabilities), financial covenants could be negatively impacted. As a result, covenants based on leverage could become out of compliance. Do not let the fact that the standard is a year away from implementation cause complacency. Remember, the agreements you execute or are committed to today may be in effect for several years, and the assets required to be recorded under the new standard are recorded as long-term assets, whereas the lease liabilities are required to be broken out as both current and long-term liabilities based on the payment terms. As a result, working capital could be negatively impacted by the recognition of the leases.

Lease versus Non-Lease Components

As part of the new guidance, the leasing standard will require companies to separate the lease versus non-lease components of the lease and record them separately. For example, if an organization enters into a contract to lease real estate, equipment, etc. and the contract also provides management services, the lessee would have to determine the amount of the contract related to the real estate, equipment, etc. and record that in accordance with the lease guidance. The non-lease component, such as management services, would need to be recorded separately. However, the organization can make an accounting policy election to account for all lease components and non-lease components as a single lease component and recorded accordingly, as a practical expedient. This election would be by class of underlying asset.

While the lease standard has a significant impact on lessees, there are no significant changes to lessor accounting. In most cases, we don’t anticipate any changes to combined lessor/lessee financial statements.

This new lease guidance will have considerable accounting implications on financial statements. The new lease guidance also adds additional disclosures to the financial statements, so now is the time to begin evaluating the potential impact of this new leasing standard and working on adopting it as soon as possible.

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