With the FASB’s new lease standards going into effect at the end of this year, CPAs need to be advising corporate clients about how to best address them, so here’s what to know before it’s too late.
To review, the new standard (ASC 842, Leases) goes into effect on Dec. 15, 2018 and requires companies to move the future costs of their operating leases from the footnotes (where those costs are reported now), to be listed as liabilities on the balance sheet. A corresponding “right to use” asset also gets reported on the asset side.
How big will the impact of that change be? We’ve been tracking corporate disclosure of leasing costs for years and have some numbers:
- Among more than 3,000 public companies we studied, total off-balance sheet leasing costs were $1.04 trillion as of July 1, 2018. (We estimate the net present value of those costs at roughly $860 billion.) S&P 500 companies had an average leasing liability of $1.3 billion; the remaining 3,052 companies in our sample population had average liabilities of $105 million.
- In absolute dollar terms, the industry sectors with the largest leasing liabilities are consumer discretionary ($327.5 billion), industrials ($123.1 billion), and financials ($117.2 billion).
- When you compare leasing liabilities to total current liabilities, the sectors with the highest ratios are consumer discretionary and healthcare (6.5 percent each), industrials (5.7 percent), and telecommunications (5.6 percent).
So without question, the new leasing standard will have a significant effect. The statistics above, however, only tell a large tale across all companies.
When you start to look at specific companies, even more eye-popping scenarios suddenly become much more plausible. Let’s consider three of them:
1. A big effect on liabilities, potentially even a huge one. We found 24 companies whose leasing liabilities, once added to the balance sheet, will increase total liabilities by 200 percent or more. Five of them will see their liabilities increase by more than 300 percent, and two — Five Star Senior Living, and Potbelly Corp. — will see total liabilities increase by 456 and 447 percent, respectively.
Those are staggering amounts, and companies need to understand the implications. For example, a sudden spike in liabilities might trigger a debt covenant and have creditors knocking on your door.
2. A big effect on assets, too. All those liabilities will be offset by “right-to-use” assets on the other side of the balance sheet. Again, the implications for financial departments could be significant.
For example, by adding more assets to the balance sheet, this new standard increases the denominator when calculating return on assets (net income ÷ total assets). That pushes your ROA number lower, without any fundamental change in business operations.
In 2017 the S&P 500 had $1.05 trillion in net income and $34.4 trillion in assets, a return on assets of 3.04 percent. This group also had $631.3 billion in future lease payments as liabilities. If we add an equal $631.3 billion to the asset side as well, adjusted ROA falls to 2.99 percent.
We also examined the current and adjusted ROA for S&P 500 companies individually, using the same logic. Eight companies (including Ross Stores, Starbucks, TJX Co., Ulta Beauty) would see their ROA fall by more than 5 percentage points. You may want to measure your own shift in ROA and start talking to investors about it.
3. Another avenue for impairments and earnings surprises. Like goodwill, inventory, and other assets on the balance sheet, these new right-to-use assets will be subject to possible impairment. Imagine a retailer that signed a 20-year-lease on shopping mall space in 2011, and Amazon entering that retailer’s market in 2012. Do you really believe those leases will still be worth their expected value in 2030?
Indeed, impairment of leased assets is already happening. We found one filer earlier this year that wrote off a $459 million “impairment on equipment.” In theory, a filer could even use impairments on leased equipment for earnings manipulation: you’re already facing a bad quarter, so you include a lease impairment to make numbers truly awful, and then enjoy a bigger rebound in the next year’s period. Perhaps you even renegotiate the lease and report a “gain on modification of lease.”
So again, all of this is happening soon. The new standard will change how your clients
- manage policies and documentation for leasing
- work with auditors newly skeptical of a more important balance sheet item
- communicate with investors about key business metrics
With two months to go, your corporate clients may want to start thinking about how to panic effectively.
About Pranav Ghai
Pranav Ghai is CEO & Co-Founder Pranav. He is an analytics professional who has built expert systems that interact with information to return actionable ideas.