As we head into spring, one of the biggest changes in public accounting standards is looming closer each day. In 2016, the Financial Accounting Standards Board (FASB) announced an accounting standards update (ASU) — ASU No. 2016-02 — which will improve the ways banks report and track their operating leases by essentially recording information historically considered “off the balance sheet” directly onto their financial statements.
While discussion of reevaluating the standard has been going on for more than a decade, it was always just that — talk. However, with the update now imminent, all companies, including banks, will be required to adopt the new standards. Granted, private companies still have over a year to comply with a deadline of Jan. 1, 2020, but public companies will need to start much sooner, to meet the Jan. 1, 2019 adoption requirement deadline.
Banks’ operating leases will be considered a right-of-use asset (ROU) after the new standards are implemented. This means they must be capitalized on the balance sheet, unless the lease falls under the 12-month mark (note any extension options would need to be assessed, as well, for determination under the new guidance). The new standards will also require companies to report a related lease obligation on the balance sheet for their capitalized ROU assets. This will apply beyond building leases, such as real estate, vehicles and equipment that exceed one year. Under current guidance this has been the case for capital leases, but for any lease that has been deemed to be an operating lease, the company will now be required to add it to the balance sheet.
While FASB does provide some fairly straightforward guidance for what banks need in place (and should be doing) to be ready for the updated lease standards and considerations, there will likely still be many questions, concerns and confusion.
It may seem as the deadlines are far away at this point, the intricacies of the new standards will require a significant amount of time and attention to ensure smooth implementation. So what impact can banks realistically expect from these new standards and what should they be doing now to get ready?
Preparation is Key
To prepare for the new accounting standards, some bankers are already hiring expert consultants or supporting vendors, purchasing outsourced products or software, or at the least, creating an in-house spreadsheet to account for the changes. The first issue (and most obvious) will be to initially identify all outstanding leases. Once this is done, banks can then determine and begin to quantify any problems associated with the calculation of the ROU asset and lease liability. This sounds simple, but in reality, can be a long, drawn out process and could significantly increase the workload for any accounting department (appropriately setting up amortization schedules alone is very tedious and time-consuming). While something like one or two long-term leases with minor changes should not be too much of a burden, when this increases to 10 or more leases — each with varied levels of renewal options, ending dates and renegotiations — suddenly your workload has grown exponentially.
The Potential Impact from Compliance
The main driver behind the new standard update is to move it from a rules-based standard to one that is principles-based. As stated previously, the new guidelines assert that all leases with terms longer than 12 months will be recognized as an ROU asset, which currently will be 100 percent risk-weighted. This will, in turn, increase the risk weighting of a bank’s total assets, along with the total average assets for any leverage calculation, while at the same time decreasing its capital ratios. While it is possible regulators may eventually create some additional guidelines for how risk is weighted, banks should expect an imbalanced asset calculation at best.
Loan Covenants
It is highly suggested for those lenders with loan covenants that are based on total liabilities to conduct a comprehensive review prior to the update. This could not only help ensure a smooth implementation of the new standard, but also lessen the chances of any surprises down the road after adoption. FASB has openly stated that it may require both lenders and borrowers working together to ensure that any changes resulting from the new standard does not create technical defaults that could “sour” good customer relationships. In addition, banks may find it a good idea to be proactive and start these conversations by reviewing existing loans and engaging those borrowers during the process to help avoid any surprises over the accounting change as well.
Changes for Debt-to-Income
While FASB’s updates will not impact any finance leases (typically known as “capital leases”), these will continue to be considered as debt on the books. Moreover, operating lease obligations that have not been historically required to be listed on the balance sheet will now be considered an other liability (as opposed to debt). This represents a major change from an accounting perspective, but most banks should not expect to see a big impact on their debt-to-income ratios from it.
Where do we go from here?
While the consensus seems to be that the few existing leases will not pose a problem for most, the bottom line is that all banks should give serious attention to this update. In truth, any lease which is absent of an exemption could be a potential risk. Banks should be proactive in their preparations and have a plan already in place for the new standard. Being prepared will not only help make the initial transition a smooth one, but capturing and thoroughly reviewing all leases and their respective details will also help protect against – and even prevent- many long-term financial headaches in the future, as well.
Mathew Shoemaker, CPA, is audit manager at PKM, an Atlanta-based accounting and advisory firm serving public and private organizations in the financial services, insurance and technology industries.
