Changes to ASC 842 Lease Implementation

By: Greg Uszak, CPA, CHFP- Senior Healthcare Advisor

On October 16, many businesses experienced a momentary sigh of relief, as the Financial Accounting Standards Board (FASB) voted to delay the effective date of modifications to lease reporting provisions under Accounting Standards Update No. 2016-02, Leases (Topic 842) (Leases).  The standard went into effect on December 18, 2018, for all publicly traded entities, not-for-profit conduit bond obligors, and employee benefit plans that file or furnish financial statements with the SEC.  The Board decided to defer the mandatory effective date for Leases for all other entities by an additional year. Therefore, Leases will be effective for all other entities beginning after December 15, 2020 (January 1, 2021, for calendar-year-end companies), and interim periods within fiscal years beginning after December 15, 2021 (January 1, 2022, for calendar-year-end companies). Early adoption of the standard will continue to be allowed.

While this deferment provides short term relief, organizations, and particularly healthcare organizations, should use the additional time to minimize the future burden of implementing the standard.

Many organizations are still processing the changes that will be reflected in the body of their financial statements, such as recording all leases with a duration exceeding twelve months as a right-of-use asset (ROU), as an asset and liability on their balance sheet.  During this transition, organizations should also take the time to consider the broader financial implications of the standard.  In particular, organizations should review existing agreements for potential embedded leases, as well as review the impact that changes within their financial statements have on existing financing agreements.

Embedded Leases

For purposes of ASC 842, a contract is a lease if it conveys the right to control the use of a specified asset over a period of time in exchange for consideration. It is common for service and purchase agreements to convey to the customer the right to use a specified asset during the term of the contract.  Within healthcare, it is common to have contracts to purchase various disposable and consumable products for patient treatment. The respective vendors will sometimes provide medical equipment that is used in conjunction with the consumable products at no cost to the provider. 

An example of this may be lab equipment that the healthcare provider received at no additional cost after purchasing a certain amount of supplies from the vendor.  Even though no payment was made for the equipment, the provider would more than likely have an embedded lease associated with the equipment. Even though no payments are explicitly related to the equipment, the healthcare provider would have to allocate a portion of the contract fees towards a lease liability.

While an example like this may, by itself, have an immaterial effect on the financial statements, they may become material when aggregated with similar contracts the provider may have with other vendors.  To identify embedded leases, healthcare finance teams should coordinate across their operations to identify these types of situations.

The Broader Financial Picture

When implementing ASC 842, an organization’s financials will potentially recognize both favorable and unfavorable adjustments.  The primary objective of each organization should be to identify the impact of the changes and to begin discussing the results of the changes with impacted parties.

Favorable changes brought by ASC 842 may come in the form of an increase to an organization’s EBITDA.  Items that may previously have been expensed will now be capitalized, and the increased lease amortization could be added back to earnings when calculating EBITDA.  For organizations that have a financing agreement or entity valuation based on EBITDA, this could be advantageous.

Unfavorable changes to be aware of when implementing ASC 842 are tied to existing debt and financing covenants.  With the increase in assets on your financials, you will now have a corresponding increase in liabilities.  Several financing agreements utilize metrics such as the Current Ratio, Debt Service Coverage, Interest Service Coverage, or Debt to EBITDA.  What metrics does your lending agreement use?  Do your agreements utilize EBIT or EBITDA?  It is important to be aware of the specifics, as changes in reporting requirements could impact several of these ratios.

If there are unfavorable changes to your financials, begin discussing the changes sooner rather than later.  Lenders are aware of the impact that the new standards will have, and they may allow for calculations used in current agreements to be used going forward and grandfathered in under “frozen GAAP” provisions.  However, not all agreements contain this flexibility, and you should also evaluate new financing agreements for this option.  Regardless of what provisions your financing agreements contain, you should be prepared to report ratios using both old and new standards.

While there is now more time to implement ASC 842, organizations should utilize the time to prepare for the adoption of the new standard.  Organizations should take measures to ensure that they have accounted for embedded leases and are working to maintain compliance with their financing agreements.  While these changes may be challenging, Holbrook & Manter is available to help guide you through the process.