Are you ready for a 15-fold increase to lease liabilities when ASC 842 is in effect
When FASB released its latest update to lease standards, ASC 842, many commentators warned that balance sheets would blow up. That has been the case among the public companies that have been implementing it since the first quarter of 2019, according to a new report by LeaseQuery.
Under the previous standard, only leases that qualified as capital leases were on the balance sheet. Operating leases, which are generally for things such as equipment or real estate, were not.
However, investors and other stakeholders complained that getting a handle on a company’s long-term obligations required digging through footnote disclosures, so they requested common treatment for both types of leases. In response, FASB released ASC 842, which I wrote about here, with the goal of increasing transparency for leases. This standard has been effective for public companies since 2019, while private companies and most not-for-profits got a reprieve until 2021.
Lease liabilities blow up
LeaseQuery analyzed the balance sheets of more than 400 companies pre- and post-transition, and found that the average lease liability had increased nearly 15 times, by 1,475%. On average, pre-transition companies had $4.4 million in lease liabilities on their balance sheets. Post-transition, that expanded to $68.9 million.
Some industries were hit especially hard. For example, financial institutions that use many operating leases for office space and branch locations saw an average increase of 6,070% to lease liabilities. Financial institutions will soon get a double whammy, when the new standard for credit losses, also known as CECL, becomes effective. Large public companies are implementing CECL starting Jan. 1, 2020, while smaller public companies, private companies and not-for-profits have until Jan. 1, 2023.
The least impacted group, according to LeaseQuery’s analysis, is manufacturers. Lease liabilities for this group increased on average “only” 495%. This is still a steep increase, but seems small in comparison. Manufacturers commonly lease equipment and may also be lessors themselves.
Between the extremes are the healthcare, restaurant, energy, and retail industries, which had these increases to total liabilities:
- Healthcare: 1,817%
- Restaurants: 1,743%
- Energy: 1,542%
- Retail: 1,012%
All of these industries use operating leases to varying degrees for equipment and real estate. These dramatic increases may serve as a wake-up call for advisors as to the possible magnitude of changes for their clients.
What does this mean for companies?
At the very least, this will require a learning curve for stakeholders and investors. The changes to the balance sheet will cause shifts to the ratios and other metrics used to monitor performance over the next few years. Comparisons between companies, and over time, will be difficult because companies have been implementing the new standard at different times and using different transition methods. Stakeholders will need to carefully read financial statements to ensure they are adjusting these ratios appropriately.
Return-on-assets (ROA) will decrease for companies adding operating leases to their balance sheets. To balance lease liabilities for operating leases, companies will add an intangible right of use asset. This will also result in a decrease to the current ratio, which may trigger loan covenant violations. Total liabilities will also increase.
However, debt ratios, such as debt-to-equity and the debt-service ratio, should not change appreciably because the new operating lease liability is treated as an operating liability and not as an increase to debt. But, because some lenders may include operating liabilities in their calculations for these ratios, advisors should carefully read loan agreements to understand any possible impacts.
These changes to the balance sheet are also impacting stock valuations, according to an academic study cited by the Wall Street Journal. During the quarter that companies implemented ASC 842, share prices for a number of companies fell. For example, the share price for AMC Entertainment Holdings Inc. dropped by more than 50%. Share prices for most companies quickly rebounded, so this may be a temporary effect.
What should advisors do?
Private companies and not-for-profits will be implementing this standard over the next year. The additional time granted by FASB gives advisors extra time to help their clients. From the experiences of public companies, starting early is a must. It will take time to gather lease agreements, analyze them, and perform the required calculations.
Advisors should encourage their clients to contact lenders to discuss the impact of the new standard. Loan documents also need to be examined in light of the upcoming changes. Loan covenants may need revision to prevent violation.
Educating yourself about the possible impacts of this new standard will set you apart as a trusted advisor!