Buck Freeman:
Good morning. Lease accounting. I know we’re very excited about lease accounting. I know that it seems like I’ve spoken on this topic the last three Catalysts. It’s the fourth year. I know you’re wondering, what could he possibly tell us today that we don’t know, or we haven’t already heard? Well, at LBMC, we have helped several publicly traded companies and privately held companies already transitioned to these new lease accounting roles. Through that process, we’ve learned a lot. There’s been a lot of additional guidance that’s come out over the years. There’s been a lot of lessons learned from our own assistants, helping our clients. There are some very helpful updates today that I want to provide, just some changes to some ASUs as well as an exposure draft. And then I want to just talk about some implementation lessons learned.
Just a little bit about me. Lauren, go back one slide. Sorry. Just a little bit about me, I’m a shareholder at LBMC. Got A little over 12 years’ experience. I worked in healthcare my entire career. I did a lot of accounting consulting around lease accounting as well as complex transactions, business combinations, complex leasing transactions. Prior to LBMC, I had four years of software development experience at a hospital IT company. Go ahead and advance the next slide.
Regarding the agenda today, initially, just going to give an overview of the changes with this new standard. I know some of this will be repetitive, but just wanted to hit the high points. I want to give an update of what’s occurred since last year with the qualification and an exposure draft, and then I’ll dig into the implementation lessons learned.
Just a quick overview of the changes. As we are aware, presentation of our operating leases is going on the balance sheet. This is the biggest undertaking, the biggest change. We will have no change to our income statement or to our cashflow statement. So I know that’s a question that I often hear. And as the private companies are preparing for transition January 1 of 22, that’s a question I often hear is, I haven’t estimated the impacts to my EBITDA or I haven’t estimated what this will do to any of my earnings metrics. Well, the good news is it’s not going to impact us at all. We’re going to continue to have straight line rent expense even after you’ve grossed up your balance sheet for these operating uses.
We’re going to have expanded disclosures. So you’re going to be required to disclose the weighted average remaining lease term. You’re going to be required to disclose a weighted average discount rate that you use to calculate those present value of those operating lease liabilities. There’s a requirement to disclose more or less a full rent reconciliation where you denote the amount of expense that relates to capitalized operating leases as well as other brand expense categories that don’t relate to those capitalize instances. Then there’s more disclosure requirements just around the nature of leasing, the types, the classes of assets that you lease, whether it’s medical equipment or manufacturing equipment, or power utility locations, or whatever it might be.
Again, we do have some changes to our classification testing. So under 840, we have these bright-line tests, 75% of the useful life tests, the 90% test. Does the agreement contain a bargain purchase option? Consistent with 606, we’re moving away from that rules-based, bright-line based accounting roles. It’s more principles based. And so you’ll see it more comes down to a hundred 840 too. We’re looking at what is the economic substance of this transaction? Are we consuming the economic life of this asset, whether through paying for it financially, or through actual use over time, or do we intend to purchase the asset at the end of the legal lease agreement? And again, all that’s based on the facts and circumstances at the day that you enter into that lease.
And then we do have a new classification step, and this more relates to equipment. Is the asset so specialized it has no alternative lease? And that would be if you had something custom built and somehow you negotiated a lease [inaudible 00:05:39] might occur in a sale lease type transaction. Then, no surprise here, but our effective dates for our private companies have moved back to 1/1, 2022. Then, for our public companies, they’ve already transitioned and that was January 1, 2019.
Just an update on the updates that have occurred since last year. So the first was ASU 2020-05, which was as a result of the COVID pandemic. And that was a deferral, a codifying the deferral of the lease accounting standard for private companies to January 1, 2022. The next was ASU 2021-05 and this relates to lessor accounting and it relates to variable lease payments. This pertains to less orders with leases that have variable payments that do not depend on an index or a rate. So if you’re leasing something and all the payments that you’re expecting to receive from the lessee are based on a percentage of sales or a percentage of some other metric that isn’t an index or a rate, that would generally result in a selling loss, day one of leasing that asset to that lessee. This generally occurs when you have a longer term real estate lease arrangement, and it can occur in retail with common control entities.
Sometimes it can occur with public utilities or a utility plant or nuclear power plant, something like that. The update to the guidance for this issue that was identified by users was that, if it’s determined that there’s a day one loss in these arrangements, which really doesn’t represent the economics of the transaction, nobody would lease something under the expectation that it would result in a loss. Those leases will no longer be classified as direct financing or sales type leases, where you would de-recognize the equipment or the property on day one. They will now be classified as operating leases. So the lessor in these arrangements will continue to keep the real estate or the equipment on their books, and the variable lease payments will be reported to income as received on a periodic basis. So it’s some nice relief for those lessors that have a lot of these variable payment arrangements that are based on something like sales.
Current project or exposure draft that’s underway is discount rates for lessees. There’s some relief that’s coming for private companies. This is the result of the Private Company Council Consensus. Currently under 8-842 private companies, they have the option to utilize a risk free rate, which would be like a treasury, a T-bill, or something like that. But they have to utilize that relief wholesale. So you have to apply to all of your leases. So if you have some massive real estate leases, and then you have some trivial equipment leases, you have to use that risk-free rate for all of those. Now, the trouble with that is that the risk-free rates are generally very low. And [inaudible 00:09:57] borrowing rates generally are higher. So the discounting effect of using a risk -free rate is very minimal, which results in much larger lease liabilities, which could trip covenants, or it could just cause an optical issue with your balance sheet.
But now, as a result of this exposure draft, user or companies will be allowed to apply the risk-free rate expedient or option on an asset class basis. So most commonly, what I would expect is that companies that have a lot of short term equipment leases, like copiers and mailing machines, they will utilize a risk-free rate for those leases. And then for their real estate leases, which generally might be longer in nature and have much larger lease payments, they will utilize an [inaudible 00:10:59] barring. Now this expedient, or this relief is applied. You will be required to disclose that fact, but it’s expected there will be no change to the weighted average discount rate calculation.
The next thing I want to talk about is I want to dig into some of the implementation lessons learned. This is something that I’ve seen and I’ve helped implement with a few companies already. And I wouldn’t generally discuss this as an accounting approach, but the FASB recently released an example on their website of applying this approach as an easy way to be compliant with 842. They refer to it as the display approach.
I would think of it more as a snapshot approach. That’s what I would call it. But it’s a way that you can kind of navigate around all the monthly debit and credits associated with each lease. Because if you think about it, every lease that you have every month, you probably have three to four to five journal entries that you have to report. And under this approach, you just look at your lease portfolio at each reporting period and you record the ending balances. So I’m going to go ahead and if we can, go to the next slide, Lauren, and in just a second let’s go back to the previous slide. But I just want to show… Go to the next slide, please.
Yeah. So here, this is just an example of a capitalization table or an amortization table. You would have one of these for every one of your leases. The idea is that you would have a summary sheet that pulled the ending balances at each reporting period onto… Go to the previous slide, Lauren. Onto this slide. And you see that we’re just pulling the ending balances. So this would be as of 12/31, 2022 for each one of your leases. Note that all the leases have different discount rates, different terms, but we’re just pulling the ending balance. And at the top, we’re totaling what those ending balances are for the Right of Use Asset, which is in that column H, and then the Right of Use Liability, which is in column L. At the top, we’re summarizing those in the journal entry format.
So this would just be one journal entry that’s reported at the end of each reporting period. Where maybe you do this quarterly, maybe just do it once a year. I would expect that some of my clients that have smaller leasing portfolios probably just are going to want to do this once a year. Now, you might notice that the Right of Use Asset and the Right of Use Liability are not the same amount, and that’s because these leases have escalating lease payments. So the difference there is, as a result of additional lease payments or cash payments that don’t equal, the rent expense has been captured. Because under this approach, we don’t make any changes with 840 with our current accounting, we just record invoices as they’re received. So, as a result, you can see that we haven’t recorded enough rent expense. And we could prove this out by looking at the actual amortization tables and comparing those to the invoices that we received.
But high level, the reason that we record the difference to rent expense is because it’s necessary to true up your straight line rental. It’s a straight line rent adjustment is effectively why we’re doing this. Under this approach, you want to be mindful of prepaid rent or crude rent payments. You don’t want to double up. So I would expect that the first time that you go through this exercise, you probably want to analyze your prepaid balances as well as your accrued rent balances to verify that you haven’t doubled up on anything, or you don’t have any adjustments that are needed. Perhaps you’ve grossed up a prepaid rent payment, so you’ve credited accrues and you’ve debited prepaid expense. That’s common. I see that all the time as an auditor. So you just want to ensure that you’ve removed that, just with a simple reclass entry. But perhaps you’ve already expended the cash and you might need to adjust it to the P&L. Maybe you’ve got some kind of adjustment like that.
So you just will be mindful of what’s already on the balance sheet for those operating leases when you take this approach. This is something that you can adopt, you can adopt this after you transition. You can take this approach at transition. So you have a couple options there. Again, this is intended to… And I think the reason the FASB released this was, there was a lot of concern around all of the journal entries associated with this new standard. I think it’s a nice elegant approach for accounting for this. Lauren, please go to the next slide.
Again, this is just a visualization of what one of these capitalization tables looks like. This is something that you can get directly out of a software system. So if you’re utilizing software for your lease accounting, they should be able to spit out a capitalization or an amortization table, which just shows you the burn down and the related rent expense every month. Or, you can build these in Excel. Again, I’ve said this before, but if you have 25 or more real estate leases, you probably want to look at software. There’s a lot of things you can get out of software that will make your life a lot easier around business intelligence, renewals, square footage, calculations. There’s a lot of things that those software solutions can provide that can get a little unwieldy trying to use Microsoft tools.
Here, I just want to talk about some additional lessons learned. Deferred rent. I’ve spent a lot of time helping companies transition, and deferred rent is always an issue. It, It’s something that always comes up and because it’s, what do we do with this balance? Well, what should occur on a lease by lease basis is you should take that deferred rent balance and reclassify it to the Right of Use Asset. And you amortize it over the remaining life of that lease. The trouble with that is that these software systems that do all of these calculations for you, for 842, they typically calculate a cumulative difference that transition that does not equal what you’ve been maintaining in your Excel schedule for deferred rent. I’m not surprised, because those schedules sometimes, there can be issues with them or maybe there’s just maybe a payment amount that just got miskeyed.
So, to help relieve some of the issues around trying to manage the lease by lease deferred rent balance issue, I would recommend reclassing that balance in total as a single Contra Asset, to the Right of Use Asset, and amortizing it over the weighted average remaining life of the assets that it represents. So, typically equipment doesn’t have… I’ve seen it before, but typically it doesn’t have escalating lease payments. So therefore, you wouldn’t have any deferred rent for equipment. So if you analyze your real estate portfolio and you see that the weighted-average remaining useful life of your real estate leases at transition is four and a half years, then I would reclass that deferred rent balance to the Right of Use Asset as a Contra asset. And I would amortize it over four and a half years. I think I would be hard pressed to be convinced that doing it on a lease by lease basis would give you a much different result.
The next is utilizing the portfolio approach for discount rates, asset classes, lease terms. You don’t have to try to nail it with every single lease, trying to figure out the discount rates specific to every lease. What I encourage my clients and those that I’ve already assisted with this standard is, establish your discount rates once every six months or once a year or once a quarter, and utilize those rates throughout that quarter. Don’t try to, every time you enter into a lease agreement, just try to figure out what that specific discount rate would be at that point in time. Just have an accounting policy and keep it simple.
The next is lease terms. You can go down a rabbit hole trying to analyze the lease term on anything that has a renewal, especially equipment, or you can analyze history and know what you know about your business and establish a policy on lease terms for… Let’s say you have a bunch of vehicles and they generally are 40 to 55 months, something like that. And you know that you generally keep those through the end of the lease term. You could just say generally that, every vehicle that we get, we’re going to utilize 47 and a half months, just on average, that’s what we’re going to do. So you have that option to take a portfolio approach, establishing accounting policies for lease terms as well as discount rates. I would do this on an asset class basis.
You’re going to want to, at transition, I would coach you to disregard leases that expire within 12 months of adoption transition. So, if you’re a private company and you’re transitioning January 1st, 2022, and you have a lease that terminates on 6/30, 2022, you can disregard that. You don’t really need to do anything with that because in my mind, that’s a short term lease. Sure, at one point it was a very long lease, but that amount, that six months of that lease is probably trivial in the grand scheme of things.
So I’m coaching my clients to disregard those leases that expire within one year. And you think it’s material, yeah, sure. Maybe you do an analysis to determine what the impact would be. But I definitely would not put those into a software solution because every lease that you put into a software solution, they’re going to charge you for that every month. They’re going to be hitting you for $6 to $10 per month, per lease. So if you can keep those out at solution, I would.
And that’s also for vehicles, copiers, mailing machines, things that you have a large volume of that you can get the data in a spreadsheet from the vendor or from the lessor. Do the analysis in a spreadsheet, especially if you’re going to take the display approach to accounting. And you can just maintain that on a quarterly basis. Just get that data updated from the lessor periodically. I would not recommend you to utilize the practical expedient to reassess lease terms. Unless you have some business reason for wanting to do that, I would encourage you not to. The way the transition guidance is written is you don’t have to reassess lease terms at transition. So I would not do that. I would just grandfather in the lease term that you established under 840, grandfather that into 842. And then once you get under 842 and you renew that lease, then it’s a lease modification and you create a new asset or a new lease for 842 purposes.
The last thing is just consider capitalization thresholds. I think about capitalization threshold as a percentage of total assets and your total assets, depending on the amount of Right of Use Assets that you’re going to be reporting day one, are going to go up a bunch. It could go up enormously if you have a ton of real estate leases. So reconsider that capitalization threshold as a percentage of your total assets. Perhaps, this is an opportunity to refine that. Go from a thousand bucks to 5,000 bucks. That’s something to think about.
And then also materiality thresholds. Sure, you got a bunch of hand sanitizing machines around your headquarters, but in the aggregate, are they really worth the effort to determine the least accounting impact? I would think not. So have some kind of management materiality threshold for, what’s meaningful to our business? What do our readers really care about? Do they care about Coke machines? Or name your trivial lease, because we have leases all around us. So just reconsider those thresholds.
