When it comes to the hottest accounting issue for banks, the Financial Accounting Standards Board’s upcoming current expected credit loss (CECL) standard is typically what comes to mind. But there is another issue on the horizon: the updated lease accounting standards.
Earlier this year, FASB issued the update to improve how banks report and track their leases. The approach was to take the information, which has been historically considered “off balance sheet,” and record these items directly on the financial statements.
How things will change
The talks around reevaluating this standard date back to 2006 and it’s been easy to tune out that conversation. However, the new standards will be here before you know it. (Jan. 1, 2019, for public companies, Jan. 1, 2020, for private companies).
This may seem like a long time, but the intricacies of the new standards demand a significant amount of preparation.
Following the implementation of the new standard, banks’ leases will be considered a right-of-use asset (ROU), which must be capitalized on the balance sheet. (That is, unless the lease is less than 12 months long, including the extension options, which require an assessment of the likelihood of an extension.)
Implications on multiple fronts
Let’s examine the likely effects throughout your organization:
• Compliance: The entire purpose behind this standard is to convert it from a rules-based to principles-based standard.
As previously mentioned, under the new guidelines, leases with terms of more than 12 months will be recognized as an ROU asset and it’s expected that it will be 100% risk-weighted, increasing the risk weighting of a bank’s total assets, as well as the total average assets for leverage calculation, while also decreasing its capital ratios.
In time, regulators may establish some guidelines for how risk is weighted, but expect to see an imbalanced asset calculation.
• Debt-to-Income: FASB’s updates don’t impact finance leases (historically referred to as “capital leases”), which will still be considered as debt on the books. However, operating leases, which have not been previously recorded to the balance sheet, are now considered a liability.
From an accounting standpoint, this represents a huge change. Thankfully however, banks shouldn’t expect a considerable impact on debt-to-income ratios.
• Loan covenants: For lenders whose loan covenants are based on total liabilities, it’s a good idea to conduct a comprehensive review of these to make sure there are no surprises after the adoption of the new standard.
Note that FASB stated that lenders and borrowers may need to work together to ensure changes resulting from the new standard do not result in technical defaults that have a negative effect on otherwise good customer relationships.
For banks, it’s a good idea to look through existing loans and have conversations with borrowers so as to not have any surprises over the accounting change as well.
• Preparation: Banks can prepare for the new accounting standards in a variety of ways: by creating an in-house spreadsheet; hiring a consultant or vendor; or purchasing an outsourced product or software.
However the preparations are conducted, the biggest issue is in identifying all leases and then initially setting up, determining, and quantifying all of the nuisances associated with the ROU asset and lease liability—everything must be included in the calculations.
This is a tedious process. Appropriately setting up amortization schedules is time-consuming and depending on the level of lease activity could be a significant workload increase for the accounting department. A bank with one long-term loan with a few changes isn’t going to have a burden, but if there are ten loans, each with varying renewal options, ending dates and potential renegotiations, that can increase the workload exponentially.
Implementing a rules-based approach
FASB provides straightforward guidance about what banks need to do in preparation for the updated lease liability standards and associated ROU asset considerations.
Granted, there could be some confusion around the determination of the extension period, but this will require documentation and/or support from management about whether to enter or not to enter into the extensions of the lease.
There’s also an adjustment to how a bank determines if a lease is classified as “finance” or “operating.”
For this, the new guidance specifically uses major part of the remaining economic life and present value of the sum of the lease payments equals or exceeds substantially all of the fair value of the underlying asset.
This is most certainly a case-by-case decision. But as a default, it’s likely that most banks will revert back to the 75% of remaining economic life or 90% of the fair value (at least, from the start) standards.
The old bright-line tests may provide criteria for a good starting point, but documentation from management is essential in the judgement to determine if a lease is to be classified as “finance” or “operating.”
So where does that leave us?
Bankers should take this seriously, because while many believe the handful of existing leases won't be a problem, the reality is that any lease, absent of an exemption, poses a risk.
It’s better to get out in front of the new standards with a plan, especially because once all leases and their respective details are captured, it is a simple, straightforward calculation that will prevent many long-term financial headaches down the road.
About the author
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.