Doug Houser: From Rea & Associates studio, this is unsuitable, a management financial services podcast for entrepreneurs, tenured business leaders, and others who are ready to look beyond the suit and tie culture for meaningful, measurable results. I'm Doug Houser.
Don't you just hate it when you get used to doing something one way and then something unexpected comes along and flips your world upside down? Well, that's what's happening in the world of lease accounting. While the financial accounting standards board's accounting standards codification topic 842, that's a mouthful, won't actually impact companies until 2021, as always, there are steps businesses should be taking now to prepare.
Kerry McElroy and Cody Niese, here today, are leading up Rea's internal ASC 842 task force in an effort to ensure the transition is as smooth as possible for our clients. Today the duo is going to help us understand the subject of lease accounting a little bit better while explaining why the change is taking place, how it will affect businesses, the next steps, and more. Welcome to unsuitable, Kerry and Cody.
Kerry McElroy: Thank you. We generally don't say 842 but 842.
Doug: Okay.
Cody Niese: Glad to be here.
Doug: Good to know. See, I'm already learning something. Yes, glad to have you to talk about this topic. Being in the construction segment, I get this question quite a lot from clients. What's this new lease accounting standard and why are we doing this? And of course, you can explain that.
Kerry: Yeah, absolutely. So I think with any standard change, what we're trying to do as a profession is to really provide transparency to our end users. With leases, it's always been a lot of it is off the books. There's a lot of long-term leases that aren't necessarily presented. So what this is doing is bringing the lease liability, both long-term on the books, but as well as recording what's called a right of use asset. So whether it's a building, whether it's a piece of machinery, you'll have the associated asset as well as the liability on your books. That's kind of a high-level.
Doug: Which makes sense, as I have been, in my past career, a third-party user of financial information as a banker. We had clients that always tried to structure things as operating leases back in the day to keep those off the financial statements. But as you say, ultimately it is an obligation that the company still has to fulfill. So I want to see that if I'm another third party user. Is that the genesis here?
Kerry: Definitely, definitely. Really showing those liabilities, what's going to be owed into the future periods, so people can make well-informed decisions.
Doug: Yeah. So Cody, from your perspective, we got a sense of why it's changing, how will this affect clients going forward?
Cody: Yep. As Kerry mentioned, you're going to have the right of use asset as well as the lease liability. Along with that, though, liability will be split out between current liability and the long-term liability, as opposed to the right of use asset, which will just be a long-term liability.
Doug: Long-term asset.
Cody: Yeah, long-term asset, yes. So from a client's perspective, you mentioned your banking industry, one impact you're going to see is potential debt covenants. So you have the additional current liability without the corresponding current assets. So a lot of the biggest issue or the biggest covenant affected will be the current ratio. I would not say that's used as much anymore as it maybe was in the past, but debt to net worth ratios will be affected. And even the service coverage ratio, which you see a little bit more, will be affected.
Doug: Yeah. And I know in the construction world, from my own perspective, working capital is probably one of the biggest measures that is looked at externally, either by the financing provider or the bonding company. Lots of things are determined based on a multiple of working capital. And as you say, if I all of a sudden have now a current liability and no corresponding current asset, that can change that. So the best practice would be, have those conversations with those users.
Kerry: Have them now, yeah, definitely. Your operations aren't changing, the way you're doing business isn't changing. So being upfront with your lending institutions, having those conversations now, you're going to be better off a year from now when that first quarterly covenant comes along.
Doug: Now, this goes into effect, if I'm right, is it for any fiscal year after 12/15/2020? Is that correct?
Kerry: Yes, yes. We were very fortunate as a lease team. A few months ago the FASB did extend that deadline, just due to all the work that's involved with the smaller businesses, a lot of feedback from public companies and the resources that they've had to use in order to implement the standard. So they really listened and pushed back the implementation dates.
Doug: Good.
Kerry: So although there's an extra year, it's a lot of work. That's pulling out your contracts. It's pulling out, looking at your lease agreements, but also looking at contracts that may have embedded leases in it. Doing that analysis, finding a way, putting new processes in. So it's just not a quick, "We'll get this done in a month and we're good to go." You've really got to consider what all you need to do.
Doug: Not that simple. So you mentioned embedded leases and examining current contracts. So Cody, what do you say would be best practices in terms of trying to go through all that? Do you start working with your CPA now to understand those things?
Cody: Yeah, absolutely. We recommended I guess there's a couple of part process. The first part is your standard leases, your maybe buildings, vehicles, equipment, get those listed out, have a good understanding of what kind of leases you all have. In addition, there are embedded leases, which Kerry mentioned a little bit. It's your typical ... What an embedded lease is is a service contract with the right of use in that contract. An example may be if you have an IT contract, maybe there's a server dedicated to your company at a data hub. So, therefore, you were actually leasing this tangible asset associated with it in that service contract. So after you go through all your contracts, your leases, and your contracts, there are some assumptions that are going to have to be made as well in terms of getting all the key information needed to record the liability.
Cody: And some of those assumptions may be lease term. For example, you're on a year to year lease, but you expect to be in this building for another 10 years. So management's assumption is that it's going to be a 10-year lease liability. So those are assumptions that need to be made upfront, and getting the information early on and working with their CPAs is going to make the whole transition a lot easier.
Doug: So even though you might, as you say, have an agreement that doesn't specify that for all intents and purposes and in practice there's no easy way to just exit that building tomorrow, right?
Kerry: Yeah.
Doug: So you've got to essentially assume that it's a little bit different than what's stated.
Kerry: Yeah. Yeah. If it's going to economically disrupt the business, then that's also a consideration when recording leases.
Doug: Okay. Now if I think through, how do I then value these assets? So I have a right of use asset. You mentioned if I'm part of a data hub or something, but yet I have all this stuff up in the cloud. So how do I value that? How do you go about doing that?
Kerry: The value is really based on the present value of the payments. So I know we don't have a whiteboard or a spreadsheet in front of us, but one of the things that we've found out in doing this process of researching and finding ways for our clients to easily do this process, there are software solutions out there that can really walk you through all the inputs, the terms related, the discount rates related to the present value of your payments.
Doug: Yeah, because this could be all over the map, right?
Kerry: All over the place.
Doug: I'm an old finance guy, so I immediately went to discount rate and thinking, "Oh, that can just skew the value tremendously."
Kerry: Yeah. And so with every input discount rate, lease term, there's a multitude of considerations. And so working with your CPA, finding a solution, can help really simplify that process.
Doug: Okay. So will we do that for clients then, with some of the maybe software solutions that we've identified and say, "Okay, we can do this for you"?
Kerry: Yeah. In the last year, our group has demoed a few products out there. So we've demoed a few from a client-facing perspective, but we've also demoed one that we've settled on from a firm-facing perspective that will allow us to provide an additional service to our clients.
Doug: Okay, great. Now, what about, Cody, can you talk a little bit about disclosures in the financial statements? Because that's, again, one of the first things you always go to. What are the disclosures and footnotes? Is that different, or what are we going to see there?
Cody: Absolutely. So with every new accounting standard, there's another page of footnotes to add into the financial statements.
Doug: Uh-oh.
Cody: Yeah. The disclosures will be a little more detail on the type of leases, the information that Kerry mentioned, the lease terms, the discount rate, or use by the company. Just provide more background on the types of leases they have as well.
Doug: Okay, so definitely more detail there. Now, our clients are all privately held. We deal with privately held companies of all sizes, a lot of closely-held family businesses on the smaller side and some quite larger, complex operations too. Are there differences that we see in terms of materiality with regard to these disclosures and things like that? Does that have an impact, or not so much? It's really the same?
Kerry: There's always immateriality. We were talking earlier, and one of the examples that we've come up with, a group, you can imagine, let's just say I have a manufacturing facility with multiple buildings in an area. And so I just lease a golf cart to roam around. Well, that lease is most likely, it was going to be immaterial to that facility. Well, you take a country club who has 150 golf carts, then they lease all of them. Well, that's going to be a materiality consideration for them. So even if it's the same type of lease, it can be completely two different conclusions for two different clients.
Doug: Sure. Yeah, that's a very good point. What about, I always tend to see folks go to the other side too, the potential for "gaming the system," Are you seeing any discussion there?
Kerry: Yes.
Doug: What insight can you provide there, Kerry?
Kerry: So one of the things that I had been asked, there are a few considerations or exclusions. So if you can determine that your lease is month to month, or it's less than 12 months, you can just short-term lease and you don't have to record it.
Doug: Okay.
Kerry: So they get the question, "Well, what if I can make my 20-year lease month to month?" Well, is your intention month to month or is your intention 20 years? So you're looking at that complete lease term rather than what's necessarily written out in the agreement. What's the intent? Are you going to renew? So yeah.
Doug: And then you mentioned earlier the economic impact. Could they really exit that arrangement without some economic hindrance?
Kerry: Yeah, yeah.
Doug:
So that's a big part of it too.
Kerry: Yeah. If it's going to cost you a material amount of money to relocate your manufacturing facility or to relocate your corporate offices, then you've got to consider that. You probably won't be exiting that lease any time soon.
Doug: Yeah. And now, Cody, have you seen anything, I know we have lots of clients in different industries that have vehicle fleets, whether it's service repair or just for their folks to get out to different locations or things like that. Is there anything that you're aware of, that you've seen with regard to how maybe vehicle fleets are arranged, those types of leasing arrangements, anything like that?
Cody: Yes, there is. It's called a portfolio approach.
Doug: Okay.
Cody: Basically, like assets under the same type. You mentioned the vehicles. If they're all under the same terms, you can calculate liability for that specific portfolio of assets. So it does save some work as opposed to entering 100, 1,000 cars individually. You can take an approach where you add one asset for the entire fleet of vehicles.
Doug: So it would be beneficial to, if I'm a business owner, be beneficial to me to have those under one type of program, as it were, rather than have all these separate individual lease terms with different things?
Kerry: Yeah.
Doug: Because it would make it obviously way easier to have it all under one.
Cody: Yep.
Doug: So there are business considerations too, to perhaps simplifying, making things more efficient, that should be considered here?
Kerry: Yeah.
Doug: Okay. Kerry, are there any specific industries that you see more than any other being impacted here? We've talked about a lot of broad things, obviously manufacturing, construction. What about distribution, wholesale, retail?
Kerry: Restaurants. You talked about your franchisees who are going to have ...
Doug: Good point.
Kerry: Leasing their property indefinitely. You're not going to be exiting that corner of that intersection any time soon.
Doug: Right.
Kerry: That's a great place to have your business. So yeah, but manufacturing, construction, anything with heavy real estate like restaurants, franchises. I think it depends on the business too, that if your business strategy is to purchase your assets, it's going to be a much different conclusion than if your business strategy is to lease your asset.
Doug: Right. It may change your way of thinking. Are we seeing any noise out there in terms of, for example, I think of equipment leasing companies? Are they changing the way they do business or structure contracts at all? Have either of you heard anything about stuff like that?
Kerry: I have not heard anything. But in some of the discussions that I've had with other firms and how they're working with their clients is, an accounting change is an accounting change. And we don't want to see a business change their operations if we can handle the accounting change on the backside. So you want them to be able to run their operations still as efficiently and as well as they can. And then as accountants, we'll handle the accounting changes and disclosures on the back end, but operators, run your business.
Doug: Do what you do. And I largely agree with you. I just think of some, for example, some construction equipment rental shops that I know, some of which are very substantial. And one of their points of sale would be to try to, in essence, structure these things as operating leases for their customers so they wouldn't be put on a balance sheet. Well, obviously that goes out the window.
Kerry: Well, and I could also see, as we go back and talk about the portfolio approach, if that was one of your sales techniques, to say, "Hey if you lease multiple ..." "Have you considered a portfolio approach?"
Doug: There you go, there's a benefit, right? Yeah. "Take this whole fleet from us and it'll make your life easier." So certainly a lot to consider there. Now, this was delayed, right, a year in terms of implementation? So Cody, are you seeing anything that looks like it's going to change, or this is definitely now going to be coming for any fiscal year after 12/15/2020?
Cody: Yeah, I feel like they gave us our one break that we're going to get.
Doug: Okay.
Cody: SO I think it is going into effect when it is going, after the 2020 year. So there's no more break, now it's just given the private companies a chance to really get their arms around the leases they have, the agreements they have, and take a very proactive approach, which is what we're doing here.
Doug: Okay. Now, we talked about, obviously, it's already in place for public companies, right?
Kerry: Yes.
Doug: So we already know how that works.
Kerry: Yeah, so we are able to see the disclosures that they already have out there. One thing related to the delay, just to add to what Cody said, is that FASB didn't say, "Okay we're just delaying the lease standard," but they made a recommendation and they approved this, that I believe it's all pronouncements, it will be a two-year gap between implementation from public companies to private companies.
Doug: Oh, great.
Kerry: So this is really something that's going to benefit private companies in the long run, to be able to see the effects on the examples from the public companies.
Doug: That's great. It would have been nice to have that with revenue recognition.
Cody: Sure would have.
Kerry: We got on the right resource team, I think.
Doug: Yeah, exactly. Now, I know neither of you are tax experts per se, but what kind of noise are you hearing from the tax side in terms of potential impact? Obviously now we could have a difference between, say, book and tax representation, that type of thing. What do you see?
Kerry: Do you have any insights into that?
Doug: Any insight there?
Cody: I do not think there is any difference.
Doug: Okay.
Cody: I think it's going to be excluded from the tax, so it's going to be an adjustment on the return.
Doug: Okay.
Cody: To move any asset or liability.
Doug: Okay. Okay. So we'll defer discussion of that for expertise. I know enough to be dangerous with the taxes, but yeah. So again, it just points out to the fact that this stuff gets ever more complex, and you need to talk to your partners.
Kerry: Yeah, absolutely. Involve your best people around you and make the right decisions and get the processes in place.
Doug: So if I'm a business owner, do I start by talking to my CPA and just say, "Hey, can you give me some assessment as to what impact this might have on my business?" Is that fair?
Kerry: Yeah, that's very fair. I think just start the conversation. Like we said, with the delay, don't waste that one year. Start it now. Then you have no surprises coming up. Because as Cody said, this is not going away.
Doug: Yeah. And so those are the conversations we're trying to have with our clients, as we go through the beginning of busy season here and into the meat of that, when we're doing the fieldwork, we want to be out there, "Hey, let's think about this now. What do we do this year to help prep you for this?"
Kerry: Yep, start having those conversations, getting any of those lease agreements together, seeing what they may or may have not yet done.
Doug: Right. And they have a chance, then, this year to maybe do some things that can make it easier for them.
Kerry: Yeah.
Doug: So we can help guide those discussions too.
Kerry: Yeah, absolutely.
Doug: Awesome. Well, thank you both for being here and providing some insight on that. Kerry, I'm sorry we don't have Three Tigers here for us.
Kerry: Yeah, I know, I was disappointed.
Doug: I wish we did. I didn't think ahead. So shout-out to our favorite Granville haunt, for those of you who may know it.
Kerry: I'll just have to go there directly from here.
Doug: Yes, later. If you want more business tips and insight, or to hear previous episodes of unsuitable, visit our podcast page at www.reacpa.com/podcast. Thanks for listening to this week's show. You can subscribe to unsuitable on iTunes or wherever you like to get your podcasts, including YouTube. I'm Doug Houser. Join us next week for another unsuitable interview from an industry professional.
Disclaimer: The views expressed on unsuitable on Rea Radio are our own and do not necessarily reflect the views of Rea & Associates. The podcast is for informational and educational purposes only and is not intended to replace the professional advice you would receive elsewhere. Consult with a trusted advisor about your unique situation so they can expertly guide you to the best solution for your specific circumstance.
