New accounting standard on leases: Potential impacts on earnings quality and management behavior

by Bradley Cipriano
Equity Analyst, Gradient Analytics LLC (a Sabrient Systems company)

At Gradient Analytics, our forensic accounting analysis includes assessing the quality of a company’s reported earnings and the strength of its balance sheet. A key element of this process is understanding whether recently reported growth is sustainable and whether forward expectations are reasonable. New GAAP (Generally Accepted Accounting Principles) standards – such as Contracts with Customers (ASC 606), which went into effect at the beginning of this year – have distorted year-over-year growth figures, such that it has become routinely necessary for an investor/analyst to adjust income statement and balance sheet accounts to get a clearer like-for-like comparison. For example, ARRIS International plc (ARRS) has grown 2018 YTD GAAP EPS by $0.17, which includes an $0.18 benefit from ASC 606. So, while ARRS is showing earnings growth on the surface, its comparable YOY earnings have actually declined. Understanding how new accounting standards can be manipulated to positively impact earnings can help investors better assess reported results.

While such new standards are often viewed as “a wash” since there is no change to the underlying economics of a business, the changes under the new leasing standard Leases (ASC 842), which is coming into effect in 2019, may prove quite material for certain corporate filers. The new leasing standard follows a convergence in accounting principles between International Financial Reporting Standards (IFRS) and U.S. GAAP to improve comparability among different filers. Currently, operating leases (which are similar to debt) are disclosed off-balance sheet in the footnotes with limited qualitative or quantitative disclosures. But following the adoption of the leasing standard, this debt must be brought back onto the financial statements along with increased disclosure requirements. It is important to question why a company has relied on off-balance sheet debt in the past to better understand the risks that may surface once this debt is brought back onto the statements.

In this article, I explain ASC 842, summarize the major changes it introduces and its expected impact on corporate financial statements, and discuss how this new leasing standard allows for management subjectivity that might be used to distort earnings growth and disguise a firm’s sustainable operating performance. Read on….

What is ASC 842?

Under current GAAP rules (ASC 840), leases are classified by lessees as either capital or operating and are each accounted for differently. Following the adoption of ASC 842, leases instead will be classified as either financing (similar to capital leases under ASC 840) or operating leases. Current rules promote a lack of transparency because they do not require lessees to recognize assets or liabilities arising from operating leases. As it stands, analysts reviewing a company’s financial statements have had to make their own adjustments to reported asset and liability accounts to evaluate the firm’s true financial position. But the new leasing standard requires an organization to recognize lease-related assets and liabilities on the balance sheet regardless of whether a lease is classified as an operating or financing lease. ASC 842 also requires additional disclosures to improve the transparency and comparability of a lessee’s financial statements. The new standard will be effective for public companies reporting under U.S. GAAP for annual periods beginning after December 15, 2018, which means 01/01/19 for companies reporting results on a calendar-year basis, and it primarily applies to property, plant and equipment (PP&E) leases.

The new standard also changes how leases are identified. ASC 842 conveys the right to control the use of identified PP&E assets for a set period of time, while a lease under previous rule ASC 840 conveyed the right to use PP&E, with the critical difference being control, and under the new standard, a contract contains a lease if the lessee (customer) enjoys substantially all the economic benefits and the right to direct the use of the asset throughout the terms of the lease. Furthermore, ASC 842 revamps the financial reporting requirements for both lessees and lessors, but primarily impacts lessee accounting. It effectively requires a lessee to recognize both a right-of-use (ROU) asset and a liability for each lease. However, a lessee may elect to not apply the recognition requirements for short-term leases (<12 months) and instead continue to account for the lease as an operating lease under ASC 840 (i.e., off-balance sheet).

To summarize, ASC 842 revamps the financial reporting requirements for both lessees and lessors, but primarily impacts lessee accounting. Firms with operating leases that have a lease term longer than one year will be required to capitalize a related lease asset and liability on its financial statements and provide additional qualitative and quantitative disclosures.

Why does it matter?

In a rising interest rate environment coupled with quantitative tightening, what impact will the capitalization of billions (or even trillions) of dollars of debt have on businesses? Since the announcement in 2009 that the FASB was revising ASC 840, there has been strong push back from certain organizations, particularly within the commercial real estate and equipment leasing industry. These industries are concerned that the “penalty” of bringing leases on-balance sheet may motivate businesses to purchase an asset instead of lease it. Although the new standard does not impact the economics of a business directly, one has to ask the question, why was the debt kept off-balance sheet in the first place?

While it is tempting to ignore the new standard as just a change in accounting treatment, the ramifications of ASC 842 go beyond accounting. Bringing the debt back onto to the financial statements may impact future decisions made by executives. To illustrate, imagine a company that has a long-term asset, such as real estate. Under ASC 840, a company could convert the long-term asset (PP&E) into a current asset (cash) by performing a sale-and-leaseback transaction. If the lease was classified as an operating lease under ASC 840, the lessee’s rent obligation (often noncancelable) was only disclosed in a footnote to the balance sheet rather than as a liability. As a result, the lessee was able to improve its current ratio (current assets divided by current liabilities) which improved its liquidity metrics and its ability to borrow future capital. This was done without increasing the firm’s as-reported debt burden.

Thus, it is likely under the new standard that a sale-and-leaseback transaction may lose its appeal to executives going forward since the related obligation from a transaction must be displayed on the financial statements rather than the footnotes. We already have seen our concerns manifesting in recent earnings reports. For example, Walgreens Boots Alliance (WBA) did not perform a single sale-and-leaseback transaction in FY2018 after averaging about $310.6 million per year in such transactions during the previous five years. Because WBA holds about $31 billion in operating leases, it stated in its most recent 10-K (10/11/18) that the new standard “will have a material impact on the Company’s financial position.”

Moreover, we believe the new leasing standard ultimately may reach beyond the balance sheet and impact all three statements in both favorable and unfavorable ways. For example, it may be favorable to industries that are typically valued on EBITDA and FCF metrics but may be unfavorable for those typically valued on EPS multiples. Thus, it is important that investors understand how ASC 842 will impact a company’s financial statements to better gauge the quality of reported earnings. Some leases that were once classified as an operating lease may now qualify as a finance lease under the new rules. The new rules on this are more judgement-based, which may change how leases are classified going forward, and could impact all three financial statements (Income Statement, Balance Sheet, and Cash Flow statement) if leases are reclassified from operating to finance (or vice versa).

Currently, a company utilizing operating leases records a straight-line rent expense on the income statement. However, following the transition to a finance lease, the company will have to bifurcate its rent expense into depreciation and interest expense. This may have a material impact on metrics that rely on EBITDA calculations (e.g., EV/EBITDA), as EBITDA will increase following the exclusion of operating rents. On the other hand, EPS may be pressured as the expenses will be front-loaded (due to the “effective interest rate method” used to calculate interest), which will pressure earnings in the early years of a lease and thus reduce the forward earnings growth rate.

While there isn’t a cash impact from the adoption of ASC 842, the presentation of operating cash flows and free cash flow may benefit from the transition to finance leases. Rent expense, which is included in operating cash flows, will be broken up into interest and depreciation with a portion of the rent expense turned into a reduction in principal, which will be moved down to the financing section. As a result, investors/analysts need to be cognizant going forward that an improvement in CFOA and FCF was not due entirely to the adoption of ASC 842 and/or shift from operating to finance leases.

Earnings quality concerns related to ASC 842

While consideration of all possible consequences from ASC 842 is outside the scope of this article, we believe there are certain items and disclosures that users of financial statements should be mindful of going forward.

First, the transition from ASC 840 to ASC 842 does away with specific thresholds (i.e., lease term vs. useful life and present value of lease payments vs. fair value) for determining whether a lease is operating or finance and introduces a more judgement-based approach. A key area of judgement for management is in scoping, or determining what contracts are within the definition of a lease. Companies may differ in their approach to scoping, which may lead to different capitalization practices. Investors/analysts should pay close attention to disclosures that discuss management’s judgements to gain an understanding of whether management is using an aggressive or conservative approach. For example, an aggressive reporting entity may structure leases with terms less than 12 months to avoid capitalization of the asset and related liability, which would lower a firm’s as-presented debt burden.

Lessees also will need to discount lease payments at either the implicit rate in the lease or at an “appropriate” incremental borrowing rate. The choice of discount rate is important because it impacts the present value of the ROU asset and lease liability and the amount of interest and depreciation expense to be recognized on the income statement (a higher discount rate will reduce depreciation but increase interest expense). Moreover, a higher discount rate can accentuate the impacts of front-loading and pressure EPS in the early years of a lease. Thus, the discount rate can be gamed to help meet earnings expectations. Investors should make their own assessment of whether the discount rate used is appropriate or has been massaged to tweak reported results.

Moreover, a change in the classification of a lease from an operating to a finance lease (or vice versa) can change expense recognition and cash flow presentations. As illustrated above, switching from a finance lease to an operating lease would generally increase EPS but lower FCF and EBITDA. As such, investors should examine lease-related disclosures to ascertain whether reported earnings growth can be attributed to excessive contract modifications – an unsustainable trend.

Summary

While ASC 842 is “just” an accounting change, indeed it represents one of the largest and arguably one of the most impactful reporting changes to GAAP in decades. The standard may bring over $1 trillion of debt onto the balance sheets for GAAP reporting entities in 2019, which unfortunately coincides with the burdens already introduced by rising interest rates and quantitative tightening. However, it remains to be seen if ASC 842 will materially impact companies beyond their financial statements.

The new standard brings lease-related liabilities and assets onto the balance sheet regardless of whether the lease is classified as an operating or finance lease (although leases less than 12 months are exempt). This will impact the balance sheet for numerous firms across a variety of industries while the income and cash flow statements likely will not see a material change in presentation following adoption. However, the definition of a lease has been modified as has the scope of what constitutes a lease, which may impact how a lease is classified and its related accounting treatment.

The shift from a rules-based approach to a principles-based approach increases the opportunity for management subjectivity and financial gamesmanship. We highlighted a few different ways management could augment as-reported earnings, including scoping, choosing a discount rate, and lease modifications.

Overall, Gradient applauds the FASB for issuing new rules on this subject as they ultimately improve transparency surrounding often opaque operating lease disclosures. Nonetheless, the new standard can be gamed in a way that can unduly benefit reported earnings in the short term. As such, it will be paramount for investors to read and understand lease disclosures and the related impacts that adoption may have on earnings going forward.