How FASB and debt markets will grade healthcare organizations’ leases
- Because of the prevalence of capital leasing for many companies, FASB and IASB have amended accounting guidance (ASC 842) to provide more reporting on lease transactions.
- IASB and FASB differ on how operating leases will be disclosed and valued on the financial statements. For this purpose, we will focus on the FASB guidelines.
- The new accounting standards require organizations to recognize all lease obligations (over 12-months) on their balance sheets, to ensure greater transparency in financial reporting.
- Healthcare providers will need to begin monitoring the potential effect of these changes on their debt-to-capital ratio and related debt covenants.
- Regulations take effect in 2019 and 2020, but back reporting begins in 2017 (for public companies) and 2018 (for private, non-profit and government organizations), so time is short to understand and manage implementation.
- Hospitals and health systems will be particularly affected by the new reporting standards due to the capital-intensive nature of healthcare service delivery.
- Missteps in managing this change can result in loan covenant defaults, souring investor sentiment and/or failure to meet benchmarks.
Leasing is an important activity for many organizations to gain access to assets, obtaining financing, and limit risk. But it has also been an opportunity to remove debt from a balance sheet and bury obligations. Healthcare entities will need to change certain lease accounting practices when implementing FASB’s new leases standard and those changes could impact financial/lending covenants.
On February 25, 2016, the Financial Accounting Standards Board (FASB) officially released its long-awaited lease accounting standard, which now requires companies to report most leases on their balance sheets and puts an end to the off-balance-sheet reporting of assets and liabilities. This represents a unique opportunity to uncover accounting of operating expenses within lease agreements previous hidden in the footnotes, measure better than peers against benchmarks and optimize obligations going forward with these new accounting standards.
Why Change Now?
The 2015 accounting models for 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, there has been a widespread request from users of financial statements and stakeholders (investors, lenders, the Securities and Exchange Commission, and the Internal Revenue Service) to change the accounting guidance so that leases would be recognized as assets and liabilities instead of honorable mentions in quarterly filings.
Both FASB and International Accounting Standards Board (IASB) have decided that allowing Tenants to keep certain assets off their balance sheets has created too large of a “blind spot” in the system.
The 2016 update to FASB’s Accounting Standards Codification (ASC) Topic 842 reflects the input FASB received during more than six years of work and numerous outreach sessions to gather feedback from key stakeholders prior to its finalization last February. The most significant change in the new standard will now require organizations that have operating leases with terms of more than 12 months to recognize assets and liabilities on their balance sheets.
The objective of the new standards is to increase transparency and comparability among businesses. The new rules will change how businesses 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.
Previously, the recognition, measurement, and presentation of a lease’s expenses and cash flows depended 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 new standard requires virtually all leases to be placed onto the balance sheet.
Under the new guidelines, most leases currently considered capital leases will be known as Type A leases, while most leases that are categorized as operating leases will be known as Type B leases.
The main difference from current accounting for operating leases is that the lease will be on the balance sheet (as a non-debt liability) rather than appearing as a table of future payments in the footnotes. But the lease doesn’t just appear as an obligation. Just like an asset financing in a lease transaction, the rights to utilize the asset will be recognized by an offsetting Right-of-Use (ROU) asset rather than the leased equipment or property itself. 
No longer able to structure lease agreements to achieve off-balance-sheet reporting, healthcare organizations will need to monitor the effect of this change on their finance ratios and related loan covenants, among other things. Balance sheets will grow with higher reported capital spending and select hospitals could see their debt load grow by as much as 30%.
For operating (Type B) leases, Tenants will be required to:
- Recognize a right-of-use asset and a lease liability, initially measured at the present value of the lease payment (with some adjustments), in the statement of financial position.
- Recognize a single lease cost, calculated so that the cost of the lease is allocated over the lease term on a generally straight-line basis.
- Classify all cash payments within operating activities in the statement of cash flows.
The good news is that even though the lease value is on the balance sheet, it continues to be treated separately than a finance lease and will remain an operating activity.
The new guidance mostly affects accounting for Tenants in leasing transactions; however, these changes for Landlord accounting will impact hospitals substantially more than the typical organization because of the number of owned assets that are leased to physicians.
Unique Impact on Healthcare
Hospital systems will be uniquely affected by the proposed standard due to the capital-intensive nature of healthcare service delivery. Medical providers commonly operate as both Landlords and Tenants of real estate. In addition to the leasing of equipment, leasing of physician office space has become standard operating procedure for today’s healthcare systems. In fact, it has grown considerably with the expansion of ambulatory care. Master leased outpatient facilities, ground leases and air rights on hospital campuses add complexity to the reporting at a time when hospitals are increasing leased facilities by establishing presence in more off campus and retail settings.
Hospitals have distinctive arrangements that under new lease accounting can alter its perceived financial strength, as well as compound the administrative burden and complexity of financial reporting. For example:
- Hospitals will need to deal with both Tenant and Landlord accounting.
- Use of ground leases and air rights to third parties on hospital campuses will need to be reported under the new standard.
- Sale-leasebacks and build-to-suit arrangements will be easier to achieve operating lease classification than under current standards, meaning that more commercial arrangements will comply.
Is it Going to Affect Your Core Business? Do You Borrow Money or Have Investors?
The calculations of many of the key ratios governing bank covenants, such as earnings before interest, taxes, depreciation and amortization (EBITDA), debt-to-equity (D/E) and return on assets (ROA) are bound to come out a whole lot differently for many entities.
The new standard will increase an organization’s total assets and liabilities in most cases without any related change to its equity. These additions may negatively impact certain financial performance measures, including computation of tangible net worth and various metrics related to an entity’s total liabilities. It could give investors the impression that it’s less efficient in its deployment of capital than they previously thought.
Healthcare providers may be faced with added pressure on leverage and credit ratings. Compliance with financial covenants will need to be evaluated based on the proposed changes. Debt ratings, however, are likely to be unaffected. Lease payments under operating leases, which are currently deducted in arriving at net income, will continue to be reported as a lease expense, but will straight line over the life of the lease instead of expensing the amount that is actually paid each month. As such, the new standards will negatively impact net income in the early years of a lease, when the straight line expense exceeds the historically lower stated lease amount, and positively impact net income in the later years of a lease, when the straight-line expense is lower than the historically higher stated lease amount.
In addition, because the new rules value future lease payments, there may be an initial reaction by healthcare entities to adjust leases in the following ways to limit impact to the balance sheet.
- Shorter Lease Terms. The longer the lease term, the greater the up-front future lease payment liability a Tenant must record on their balance sheet. Therefore, Owners/Landlords can expect Tenants to ask for shorter lease terms and more renewal options.
- Triple Net Leases. The new Rules will require a Tenant to record only the present value of future lease payments such as fixed rent during the initial term of the lease. As a result, Tenants will want to reduce the liability reported on their balance sheets by separating the non-reportable future variable payments (such as taxes, insurance, and CAM expenses) separately from fixed payments. The clearest way to accomplish this is to structure a triple net lease in which the Tenant agrees to pay a smaller fixed rent augmented by a pro‑rata share of taxes, insurance, and CAM expenses, and repair and maintenance expenses that were previously included in the fixed rent.
Lease accounting will continue to require critical decision-making, such as when making estimates related to the lease term, lease payments, and discount rate. Similar to today, the term of the lease will include the non-cancellable lease term plus renewal periods that are reasonably certain of exercise by the Tenant or within the control of the Landlord.
Extensive quantitative and qualitative disclosures, including significant judgments made by management, 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 Healthcare Organizations Have to Prepare?
Implementation of these new lease requirements will be a challenge for healthcare providers, which have increased through acquisition of hospitals and physician practice groups, each with their own real estate portfolios. The new lease guidance required by FASB’s ASC 842 Leases guidelines will be effective for many public businesses and non-profit healthcare entities (that have issued or are conduit bond obligors) for periods beginning after December 15, 2018 (2019 for calendar-year entities). But 2019 figures must be back reported two years, so reporting will begin January of 2017 for most healthcare organizations and January of 2018 for private, other non-profit and governmental entities.
The biggest issue is that the way leases are measured is entirely new. That leaves us with two clear problems:
- Many healthcare organizations have no idea what the lease liability or right of use is for each of their facilities and
- Negotiated deals 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 new requirements present an opportunity to better manage leases within organizations. Entities will need to adjust their accounting policies, processes and internal controls to implement the new standard.
Going forward, healthcare organizations must develop an inventory of existing leases, as well as a call of action:
- Assess the suitability of existing lease administration and reporting systems to accommodate the new accounting requirements.
- 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.
- Ensure active management of their lease obligations on future transactions, with enhancement of lease abstracts and processes for additional data capture on existing leases.
In several instances in our practice, we have been able to negotiate terms within the agreements—details really—that involved no monetary issue, but greatly decreased the lease liability on our Clients’ balance sheet.
Accounting changes are here and most healthcare organizations have until January 1 of 2017 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 daunting 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 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.
 Katz, D. M. (Feb. 25, 2016).
 Katz, D. M. (Feb. 25, 2016).
 Petta, R. (March 11, 2016).