For decades, companies have leveraged a tactic called off-balance sheet (OBS) financing to borrow for major capital expenditures, including real estate and equipment, without having to account for them on their corporate balance sheets.
(Bloomberg Tax & Accounting)
The introduction of Accounting Standards Update No. 2016-02 by the Financial Accounting Standards Board, which codified the standard as ASC 842, requires all leases longer than one year in length to be recognized on corporate balance sheets at the discounted present value of their future cash flows in the form of right-of-use assets and lease liabilities.
The change became effective for public companies on Dec. 15, 2018, and will become effective for private companies on Dec. 15, 2019. The new standard will change how the healthcare industry views leases and business strategies in general when it comes to leasing versus buying.
The change means trillions of dollars have appeared on balance sheets for the very first time. Companies will no longer be able to take advantage of OBS financing in the form of operating leases.
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This is just one example of the finance and accounting impacts ASC 842 will have on organizations. Beyond the ending financial accounting impact, there are several other concerns for healthcare companies as a result of the new lease accounting standard:
1. Defining which contracts qualify as a lease
One of the first steps for any healthcare organization in the implementation of ASC 842 within their organization is to identify whether a contract actually qualifies as a lease. Suppose a hospital permits researchers to use redacted patient data for a research study. Does that data constitute a probable future economic benefit? If not, it does not meet the definition of an asset and the arrangement is not a lease.
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Example: Suppose a doughnut shop negotiates and signs a contract with a hospital to occupy and leverage a space near the hospital’s front entrance to sell its doughnuts through a self-serve vending machine for a five-year period. The contract specifically requires that the vending machine may be located at any one of a few areas near the front entrance. The hospital maintains the right to change the location at any time during the five-year period. There are immaterial costs to the hospital associated with changing the space because the vending machine (which is owned by the doughnut shop) can be moved easily. There are numerous areas near the front entrance that are open and that would qualify for the specifications of the space within the contract.
So does the contract contain a lease? Under these circumstances, the contract does not qualify as a lease. While the quantity of space is written within the contract, it does not possess an identified asset, as the doughnut shop maintains its control of the vending machine. The contract simply requires a space near the hospital’s front entrance, and this area can be modified at the hospital’s discretion.
The hospital has the “substantive right” to swap the space occupied by the doughnut shop’s vending machine per the guidance within ASC 842 uses because:
- The hospital has the practical ability to make the change throughout the period of use.
- The hospital would benefit economically from the substitution because it allows the hospital to make the most effective use of the space near the hospital’s front entrance to meet changing circumstances.
2. Identifying embedded leases in service agreements
Service agreements, or long-term product supply contracts, aren’t new to the healthcare industry or any industry for that matter. The differentiation between service agreements and lease contracts or service agreements with embedded lease provisions, however, has become more important than ever under the new standard. Why? Under the guidance of the legacy lease accounting standard, ASC 840, it wasn’t necessarily essential for companies to identify whether those contracts contained leases embedded within the agreement because even if they did, those leases would be expensed as operating leases on the income statement. They also wouldn’t be present on the balance sheet, similar to the treatment for a true service agreement.
ASC 842 changes that equation. Those embedded leases masquerading as parts of a service agreement will now be operating leases appearing as right-of-use assets and lease liabilities on balance sheets, and their identification is essential to financial statements free from material misstatements.
For example, say a supplier provides a customer with a diagnostic machine and the customer agrees to purchase a specified quantity of blood or urine test kits that include a testing reagent over a predetermined period of time. These types of contracts are referenced as supply agreements, but they essentially have a lease of an asset embedded within the contract.
An additional example may be seen in Siemens Healthineers’ customized service agreements and Siemens Proactive Plans. These plans are designed to provide support to critical and noncritical equipment and to provide CT, MRI, and angiography imaging systems. These service agreements will need to be thoroughly examined for identified assets, which may need to be capitalized as an operating lease under ASC 842, whereas they were expensed under ASC 840.
3. Selecting and implementing a lease accounting system
Once the analysis is done, the next key step is selecting and putting in place a lease accounting system. Consider systems built from the ground up to derive the new accounting treatment with built-in processes including transition accounting elections. Ideally, the system would allow you to centralize the analysis and lease documents.
Lastly, look for a system that connects to your ERP/General Ledger system to streamline workflows.
As with any business, hospitals need to reduce risks around the new lease accounting rules. Investors, shareholders, and lenders will be evaluating hospitals based on footnote disclosures on transition methods, leasing practices, and the increased liabilities being brought onto balance sheets. Financial metrics such as return on assets, asset turnover, and net worth are all impacted.
So start by defining which contracts qualify as a lease and then move on to find any embedded leases with lease and possibly nonlease components.
Once you have your source data organized, the last and most important step is to select and implement a lease accounting system. Following the advice above should help you reduce risks around the new lease accounting rules and set your company up for a streamlined workflow for the future.
Todd Cheney is the managing editor for the Financial Accounting Research Product at Bloomberg Tax & Accounting.