How the leases you sign may affect bond ratings
- FASB and IASB have amended accounting guidance (ASC 842) to provide more transparency for lease transactions.
- Breaking with tradition of adopting FASB standards, GASB appears poised to adopt the IASB single-lease approach over the FASB method.
- If that happens, the new accounting standards will require governments to recognize all lease obligations on their balance sheets and monitor the effect of these changes on their debt-to-capital ratio and related bond covenants.
- GASB has not yet ruled, but evidence suggests that reporting will begin in 2020 (with back reporting beginning in 2018 for most private, government, non-profit agencies).
- This change is an opportunity to better manage accounts payable for leases and communicate to the market a mastery of good financial governance, or a risk that could negatively affect debt ratings, cost of debt and the availability of credit.
Like their private business counterparts, governments routinely enter into leases for equipment and buildings, but many of those obligations don’t appear in audited financials beyond a P&L statement.
On February 25, 2016, just weeks before the Financial Accounting Standards Board (FASB) issued its new standard on leases, the Governmental Accounting Standards Board (GASB) issued an exposure draft addressing its own proposed changes to governmental leasing transactions.
FASB now requires companies to report most leases on their balance sheets putting an end to the off-balance-sheet reporting of assets and liabilities. GASB’s proposed guidance attempts to continue aligning the accounting and financial reporting of leases with the those of FASB, eliminating the current (and often complex) distinction between operating and capital leases. However, a significant difference in what the GASB is proposing actually aligns more closely with the standards used by the International Accounting Standards Board (IASB).
These reporting changes represents a unique opportunity to uncover inaccurate accounting of operating expenses within lease agreements, measure better than peers against benchmarks and optimize obligations going forward in this new accounting environment. However, the proposed changes by GASB would negatively affect debt ratings, cost of debt and availability of credit issues to state and local municipalities.
Following the Lead of FASB & IASB
The existing GASB guidance on lease accounting has been based on FASB guidance since 1989. The 2015 accounting models for both GASB and FASB leases require companies who lease an asset for their own use (Tenants) and companies who lease a property out in exchange for money (Landlords) to classify their leases as either capital leases or operating leases and to account for those leases differently. Those models have been criticized for failing to disclose the full extent of obligations to those who review financial statements. Based on 2014 public company filings, FASB found over $1 trillion in undiscounted lease obligations that were relegated to the footnotes of financial statements. As a result, Both FASB and International Accounting Standards Board (IASB) [i] decided that allowing Tenants to keep certain assets off their balance sheets has created too large of a “blind spot” among users of financial statements and stakeholders. On February 25, 2016 FASB officially released its new standard, which now requires companies with operating leases (with terms of more than 12 months or for year-to-year leases where either a) the term is likely to be renewed or b) unlikely to be cancelled) to recognize assets and liabilities on their balance sheets.
With FASB’s changes, GASB decided it was time to look at its existing lease accounting guidance to consider whether changes were appropriate. This resulted in the board’s release of proposed changes in the Preliminary Views document, Leases. Similar to FASB, GASB’s proposal of new standards seeks to increase transparency and comparability among governmental organizations. But the Leases project was also initiated because its current leasing guidance predates the formation of GASB and lacks consideration of the GASB’s conceptual framework, including definitions of assets and liabilities.
Regardless, the new rules for FASB and (those proposed by) GASB will change how organizations calculate their value and will have an impact on their real estate management, financial planning, budgeting and forecasting systems, as well as tax planning.
So What Is the Impact on Me? Two Words: Balance Sheet. Two More Words: Bond Rating.
Currently, a government’s recognition, measurement, and presentation of a lease’s expenses and cash flows depends on its classification as a capital or finance lease (such as equipment), or an operating lease (such as office space). But unlike current U.S. Generally Accepted Accounting Principles (GAAP), which requires only capital leases to be recognized on the balance sheet, the proposed standard requires virtually all leases to be placed onto the balance sheet, virtually mirroring that of FASB’s new standard.
But unlike FASB’s new accounting guide, which includes two lease classifications (operating and financing), GASB is proposing an elimination of this distinction and recommends that all lease agreements should represent financings, using a single accounting approach. This means, government Tenants would report lease payments consistent with the principles for general obligation debt, which would include the following in their financial statements for most leases:
- An intangible asset that represents the government’s right to use the leased asset (rather than the leased asset itself)
- A corresponding liability for lease payments
- Amortization expense related to the leased asset (over the term of the lease); and
- Interest expense related to the lease liability.
GASB believes these changes would enhance comparability between governments by using a single classification for leases and provide preparers of financial statements (and auditors) with guidance that is more consistent and less complex. However, fiscally challenged governments are forming joint ventures, creating new entities, and hiring outside firms to perform work for certain departments and agencies. The new entities don’t fit a traditional governmental (GASB) or commercial (FASB) mold. GASB’s proposed guidance would result in different accounting and reporting of leases by GASB and FASB institutions, potentially hampering comparability.
No longer able to structure lease agreements to achieve off-balance-sheet reporting, organizations will have to monitor the effect of this change on their finance ratios and related loan covenants, among other things.
How Could This Impact Government Debt Ratings? Will It Cause Cost of Debt to Increase?
The proposed changes to operating lease accounting could negatively impact three areas that make up 20% of the debt rating “score” in the Moody’s muni debt rating scorecard. The areas impacted are:
- operating history (revenue-to-expense ratio)
- debt to full value (ratio of debt to taxable rate base)
- debt to revenue (ratio of debt to tax revenues).
It is true that that over time, the front-loading versus level rent expense is a timing difference and lease costs will generally level as new leases replace old ones. However, the reality is the lease cost will be inconsistent from year to year. The front-ending effect is greater the longer the lease term, which is typically the case with real estate leases.
The result could be a deterioration in debt ratings and higher new issue debt costs for governmental tenants, even though the credit quality of the municipality (or its ability to meet future obligations) will not have changed. However, these accounting changes could cloud a rating agency’s ability to understand the financial results where significant operating leases are present. This will likely result in an added cost and complexity burden for many municipalities, as they seek to recast lease accounting to provide lenders, rating agencies and landlords with a “clear and accurate picture” in efforts to secure the best bond rating and lease renewals moving forward. Municipalities with a large number of real estate leases now appearing on the balance sheet, relative to similar public agencies, could appear less efficient in its deployment of capital and find themselves in a more competitive bond issuance environment.
Lease accounting will continue to require significant judgments, such as when making estimates related to the lease term, lease payments, and discount rate. Extensive quantitative and qualitative disclosures will be required to provide greater insight into the extent of revenue and expense recognized and expected to be recognized from existing contracts.
What’s Next? How Long Do We Have?
The new lease guidance required by FASB’s ASC 842 Leases guidelines will be effective for private, non-profit and governmental entities for periods beginning after December 15, 2019 (2020 for calendar-year entities) and a year earlier for public companies. But these figures will have to be back reported two years, so reporting will begin January of 2018 for private, non-profit and certain government entities. However, GASB’s final guidance has yet to be determined and released.
Once a new standard is officially issued by GASB, the biggest issue will be a new the way leases are measured, creating two clear problems:
- Companies have no idea what the lease liability or right of use is for each of their leases and
- Negotiated leases were not optimized for this new method of accounting.
Accountants stand at the ready to help manage these new regulations, but at a cost. Leases managed by even the most sophisticated Accounts Payable departments typically turn around invoices or muddle through Landlord’s presentation of base and subsequent year operating expenses. The proposed requirements present an opportunity to better manage leases within municipalities.
Going forward, government agencies will have a call to action:
- Negotiations of leases must understand the lease liability and right of use impact on financials, ratios, bond covenants and investor outlook. A proactive understanding of each must be taken into account as leases are negotiated.
- Understand what items are within your control to mitigate. Having a good relationship with your landlord can help minimize lease liabilities.
- Actively manage your lease obligations on future transactions. In several instances in our practice, we have been able to negotiate terms within the agreements—details really—that involved no monetary exchange, but greatly decreased the lease liability on our Clients’ balance sheet.
Lease accounting changes for FASB are here and even more changes for government organizations could be on the horizon from GASB. Under current FASB guidelines, most government and non-for-profit companies have until January 1, 2018 to understand how they will be measured in the future and represent those measurements in the best possible light. Organizations that fail to engage service providers who understand these issues may find their metrics out of pace with competitors who do. While the changes may seem inconvenient initially, reexamining and assessing business processes to accommodate the lease accounting changes could result in some unexpected advantages. Better information and controls can help enable better tracking and asset management, avoid redundancies and allow a company to negotiate better lease terms throughout the organization. Like anything, we will figure this out, but the market consistently rewards those who figure it out first. Be that one.
[i] It should be noted that IASB and FASB differ on how operating leases will be disclosed and valued on the financial statements. Because domestic American companies typically use FASB or GASB standards, that will be the focus of this article.
 For the purpose of this paper and clarity, we will identify Lessees (companies that lease property for their own use) as Tenants and Lessors (companies that allow others to use their property in exchange for money) as Landlords. While we’re using real property as an example, these standards extend to equipment, vehicle and other leasing categories.