GAAP Lease Accounting Standards: What Just Happened?

EO:
We've written many articles for our firm's website over the years, some of which have been published in outside journals, but we decided to wade into the podcast thing now. I'm a big fan of this format and I wanted to give it a try. We wanted to demonstrate something that can't be conveyed in print.

Both of us have deep knowledge and experience working with many clients in the construction industry. We know the accounting standards and we know how to apply them, but we're also able to provide significant practical insight into issues without driving our clients crazy. Today, we're going to talk about technical accounting matters for leases, but we're also going to try to keep it at a high level for business owners and CFOs so you don't get overwhelmed with jargon. Most of our points are applicable for many commercial businesses, but our examples will focus on the construction industry so you can better identify what we're trying to say.
So Bill, can you give us a little bit of background on the leasing standard, what the goals are, and so forth?

BR:
So for a number of years, leases were only a disclosure and a financial statement, so there was no recording of a liability, there was no recording of an asset for a lease. This was a huge risk, a very large off balance sheet liability, that a lot of people weren't aware of as they read through a financial statement. So a number of years ago, the Financial Accounting Standards Board, or the FASB, who sets the accounting rules, came across, or came up with, this new standard, ASC 842, the leasing standard. There's a couple of components to it. There's also convergence with international rules. The IFRS, or International Financial Reporting Standards, has done this for a number of years, and the US is just now catching up with what the rest of the world has been doing.

EO:
Which is making the obligation for lease payments a liability on the balance sheet. So think about a national retailer that has 10,000 stores all across the country, and each of those leases have hundreds of thousands of dollars of liabilities. When you pull it all together, it could be a billion dollars of future lease payments that were not recorded on the balance sheet, and now they will be.

BR:
Yeah, we've seen financial statements look vastly different after the adoption of the standard. As Ed mentioned, the amount of future lease payments using a discount rate still comes up to a very significant number for a lot of companies.

EO:
So our discussion is going to be primarily on the lessee side. We're assuming that most contractors lease their real estate, and they lease equipment as the user of that asset. There are standards for lessors, but that's not really applicable for this discussion. So construction companies generally have office leases, they have warehouse leases, equipment yards, that's real estate. And then, they also have equipment, they could be vehicles, they could have a fleet of trucks, they could have lots of large earth moving machinery or construction equipment that's being leased. And then, they also have the typical office copiers and other small things, which we're not going to really get into that. We're going to primarily focus on the real estate leases, and vehicles and equipment on the large scale. And Bill, want to share with some of the differences between the two of them?

BR:
Sure. So generally, an operating lease, it tends to be for an asset, like a piece of real estate, usually has a long life. The stream of payments, the lease payments, usually would not exceed a significant value that's assigned to that piece of real estate. The term of the lease is generally not for a period of time that's a significant portion of the useful life of a piece of real estate. So under those roles, under the operating versus finance lease rules, that would qualify as an operating lease.

Now, if we're looking at equipment, we're really looking to see about the useful life of that asset, and we normally see a lease term for a piece of equipment generally is pretty close to that piece of equipment's useful life, or the stream of the payments could be a significant portion of that asset's value. The other option for a finance lease would be if it's a dollar purchase option at the end of the lease, that's usually a dollar purchase price at the end of the lease would usually qualify as a finance lease.

EO:
So we're talking about operating leases and financing leases, so think real estate for operating leases and equipment for financing leases. Both of them require capitalization on the balance sheet. You have the liability is determined first, it's the future minimum lease payments that's discounted by some type of an interest rate, which we will get into the interest rate discussion a little bit later. And then, offsetting that liability is a right-of-use asset. For the balance sheet, the treatment is generally similar between finance leases and operating leases, but on the income statement there is a big difference.

BR:
Right, so an operating lease, as the payments are made, the liability on the balance sheet is reduced, and then the asset is reduced down by what's rent expense. So income statement looks exactly like it did under the old standard, you have rent expense, which is an operating expense, no different than you did before. Under a finance lease, that is treated as the asset is being amortized, so you end up with amortization expense, and then the payments are reducing the liability, and you get the reduction in liability and a component of interest expense. So what you end up with is, rather than a rental expense under the operating leases, on a finance lease, you have amortization expense and interest expense.

And the reason that's significant, something that we look at as we're working through this with our clients through the adoption process, the treatment of certain expenses for EBITDA. EBITDA is earnings before interest, taxes, depreciation and amortization. EBITDA is an important financial metric, it can be used for determining the value of a company, it is also a component of certain financial covenants, and it could also be an indicator of just the overall financial health of a company. So EBITDA which is earnings before interest, taxes, depreciation, and amortization, starts with net income, and then you add back certain items.

Now, for a finance lease, you take your net income, and then those add back items include the amortization expense and the interest expense, which results in a higher EBITDA number.

EO:
And EBITDA is one of the primary indications of value for a company to compare from company to company. So there's some planning that can be done in determining whether something's an operating or financing lease. It has a major impact on your EBITDA number and it's really important in some policy elections, and whether the lease is considered operating or financing.

BR:
Right, so the leasing standard has a couple of options that can be elected, some of them are called practical expedients, and one of them is to elect to include non-lease components in the lease payments when determining if something qualifies as a finance lease or an operating lease. Those non-lease components generally on equipment could be your monthly lease cost, and then the non-operating component would be a certain charge for each hour of usage or a certain charge for each mile. So what happens is, you have-

EO:
Or repairs.

BR:
... or repairs, yeah, there could be monthly maintenance costs that are built into the lease. If you elect to include those payments in the total lease cost, when you evaluate those total lease costs in relation to the value of the asset, it could even exceed 100% of the value of that asset, and under the lease rules, that would then qualify as a finance lease.

This is a good planning opportunity that some clients have taken advantage of as we've worked through these calculations if they're looking at a potential sale or if this is a meaningful financial covenant for them, just for something to consider. I have clients that, in the past year, have gone through a sales transaction of their business, EBITDA is the starting point, and then that times a multiple is roughly the sales price. I've seen multiples anywhere between 5% to 12%, or five to 12 times, over the last few years. So if you have a EBITDA increase of a couple of hundred thousand dollars, multiply that by five to 10 times, and that is the increase in your value of your company. So this is a very meaningful number, and something that business owners should be aware of.

EO:
Yeah, and when you're going through a sale of the company, the EBITDA is always the starting point, but then when the due diligence period, there's all kinds of adds and deducts to get your normalized EBITDA. But starting out using GAAP and following the GAAP accounting rules for leases, you have the opportunity to increase that starting point by doing this the right way.
So what do you think the effect on the covenants would be when we're now capitalizing leases where we have different treatment for the income statement? There's got to be some major changes to that.

BR:
There is, there's a significant impact on the financial statements in total, and when we talk about users of the financial statement, it's the business owner, it could be investors, it's banks and its sureties. So all very important users of the statement that you want them to, number one, be aware of this standard, you want to alert them ahead of time of what's about to happen, that you're now adding a significant asset and a significant liability to the books. You also are potentially having lease characterization changes, so what used to be an operating lease in the past may now be a financing lease, and that's something else that they need to be aware of when it hits the income statement.

Ed mentioned covenants, so if you have a debt to equity covenant, this is significantly impacted because you've picked up the operating lease or finance lease on your liability side. If you have a debt service coverage ratio that usually uses some component of net income, that is over the amount of debt-

EO:
Right.

BR:
... you're now faced with a significant change in your debt service coverage ratio. Sureties always look at current ratios, and in that case, you have non-current assets, but you have current and non-current liabilities. So everything that you look at on your balance sheet is impacted by the standard, and all of your users should be aware of it.

EO:
So we talked about determining the liability, which is the future minimum lease payments discounted at some rate, so let's focus on the discount rate. What do the standards call for?

BR:
So the standards call for either the incremental borrowing rate, which is really undefined, and so a lot of companies have used either a borrowing rate that's similar to their line of credit or other debt that they have that matches the term of the lease, or what we've seen is using a federal funds rate or an AFR rate. That seems to be the more popular, it's generally a lower interest rate, especially in the past few years. It was probably less than 1% for a federal fund rate.

EO:
Before 2023.

BR:
Yeah, we're always a year behind because we're always working on the prior year's financial statements. Now, there is a relationship between that discount rate and the capitalized asset and liability. The lower the interest rate, the less of a discount you would have, so the lower interest rate results in a much larger liability and a larger asset at the date of adoption.

EO:
So now that the interest rates have risen by significant amounts, it's almost more practical to just use the risk-free rate as a standard rather than having to go through the effort of trying to figure out your incremental borrowing rate. That's something new for this year, and last year, before all the big interest rate increases, most of our clients we were working with, their line of credit borrowing, their term loan borrowing rates, or other similar equipment loans for assets that they purchased, we would use those rates, and that created a lot of work trying to come up with that rate that made sense, that was supportable. So if you can use the risk-free interest rate, which is basically five-year treasury note from the point that that lease starts, that's probably the easiest thing to do at this point, at least while we're in a high interest rate environment.

So we were just going over the adoption of this standard and the basic components of what it entailed. Now, just remember, this was a required change based on last year for private company, so most of you have already gone through this, and it was very painful, because you had to look at it lease by lease, and it was a big exercise determining the capital, whether it's a financing lease or operating lease, crunching the numbers, looking at planning opportunities, changing all your disclosures, and all the accounting changes involved with it, it was a big deal. The purpose of our discussion today is what do we do now going forward, in year two and year three going forward?

Now, I guess the first thing to say, has there been any updates to the standards in the last year?

BR:
There has, there's a new item that came out, it's ASU 2023-01, if you're keeping track of the accounting standards, it's covering common control leases. Now, common control leases are leases between a common owner, so the owner of the construction operating company, and also the owner of the building. If it's the same owner and there's a lease agreement between those two, that's considered a common control leasing agreement. Under this new rule, you can elect to treat the common control lease based on the way the lease is worded. In the past, the classic example is the business owner has a month-to-month lease for the piece of real estate between his construction company and the land. Using the common control leasing standard, you can follow the exact wording of that agreement, and so you don't have to impute a expected useful life of that lease, you can just go with the month-to-month lease.

EO:
Yeah, let's use an example. They had a month-to-month lease for a building, and the company spent half a million dollars in fitting it out, and under the previous lease standard from last year, it's principal space, so a month-to-month lease would be disregarded. And you say, well, if you spent that much money, you're going to be staying there a lot longer than month-to-month, you're going to stay there at least seven years, nine years, whatever, pick a number, some number that's reasonable considering how much money you've spent. So then you would record the asset and the liability based on the lease payment over a certain amount of time that's much longer than the written word of the lease. So what happened in 2023 is they relaxed that standard, where you can now assume it's month-to-month, or it's a two-year lease, or whatever the number is, and account for it that way, which then would create a lower right-of-use asset and a lower liability.

BR:
Or if it's month-to-month, it'd be out of the standard altogether.

EO:
Right.

BR:
You wouldn't have to capitalize anything. And the other piece that's beneficial is, the leasehold improvements under the accounting rules, leasehold improvements should be depreciated over the lesser of their useful life or the term of the lease. So in theory, under a month-to-month lease, a million dollar leasehold improvement should be depreciated over just one month. Under this new ASU 2023-01, you can now elect to treat that asset as having its useful life for the depreciable life, so now it's over 15 years, or whatever life that asset may have.

EO:
That's excellent. So let's talk about the record keeping. How did we account for last year, and has there been any improvement in the process over recent history?

BR:
So there's two approaches. There's a lot of Excel templates that are out there, we had one that we shared with our clients, and that works well for just a few leases, if you have one, two, three, maybe five leases or so. Those Excel templates, they need to be updated on a recurring basis, you cannot run reports off an Excel template, so it only does it as a point in time, and it can be time-consuming if there's a mistake, or something needs to be revised on that lease agreement.

EO:
And you have to manually aggregate them so that you have accounting worksheets that go to your financial statements.

BR:
And there's risks that you mess that up, and so it's a lot of hands-on detailed work. Now, there are software programs out there, and we've evaluated a bunch of them, there's one in particular that we've worked with, recommended it to a lot of our clients, and we think it does a good job. It has some benefits over some other programs that we've found with the controls over the calculations and reducing some of the audit risk, and that really cuts down the amount of time and effort, and it cuts down on the risk of a miscalculation that you might have in an Excel template. I think the cutoff point is probably about five or 10 leases is about the maximum I would do on Excel versus what I would try to do in the software.

EO:
And five or 10 leases is almost every contractor. We have clients that have hundreds of leases.

BR:
Right.

EO:
And the average is somewhere about 10 to 20.

BR:
Right, I have an HVAC contractor that I think about that has probably about 100 vehicles, just vehicles, and then equipment and other pieces of leased items. Now, in their case, as we went through this lease evaluation with the client, we also looked at really the benefits of purchasing versus leasing. For years, they'd always been using leases to get their trucks, and as we looked at some of the pricing and some of the costs involved, we started to question if maybe purchasing was a better option. And as of a certain date, they've started to purchase a portion of their fleet. They feel that there is some benefit there, there is some cost savings, versus just leasing constantly and always having to re-up into new leases. Also, with the availability of equipment, they found at times that it was easier to purchase a truck than it was to try to lease another fleet worth of vehicles.

So there's more to it than just the accounting piece of, here's how a lease needs to be capitalized and recorded on your balance sheet and writing footnotes. There's business decisions that go into this, and that's where we've looked at whether it's an operating versus a finance lease and how that affects your EBITDA, we've looked at leases versus purchasing and how that affects your financial statements and worked through some of those business scenarios. This really opened up a lot of good points that we discussed with our clients.

EO:
Yeah. When you're really hip deep in the details with one client and then you have all this knowledge, and then you go to another client and you see them doing something that's a little out of the norm, that provides opportunities for us to give relevant advice to our clients, which is the value add that we're really in this for.

BR:
Right.

EO:
So it seems like we started this podcast assuming that this would be a 10 minute, that's turned into 20, and we hope that you're still with us and you've enjoyed this. We certainly enjoyed the experience of preparing this, and if you like it, please reach out to us, we're happy to hear your comments, we're happy to talk to you about planning opportunities, anything that comes up. But this has been a real pleasure.