Exposition

On February 25, 2016, the Financial Accounting Standards Board (FASB) released an update to the accounting standards, under codification ASC 842, affecting the way that all leases are reported. In essence, all leases that are one year or longer, including operating leases previously reported off-balance sheet, must now be capitalized on the balance sheet as assets and liabilities. The standard became effective in 2019 for public companies and will be effective for non-public companies in 2021. Market participants have been discussing the potential implications since FASB and the International Accounting Standards Board (IASB) formed a working group in 2006 to jointly develop a new accounting standard for leases. Some of these implications include the estimated increase of U.S. public companies’ liabilities by $2.2 trillion, lower return on assets and potential violations of debt covenants.¹ As a result, one of the most tangible effects of this new change is the added operational complexity to reporting leases on the financial statements.

In the next few pages, we will discuss the mechanics of the new standard and highlight some nuances of the lease definition that companies in the physical commodities space must pay attention to with respect to storage, transportation and other long-term commitments.

Reason for the Changes and Considerations of the New Standard

FASB’s intention with the new standard is to improve the transparency and facilitate better comparability of leasing transactions in financial statements. Under ASC 840 (the predecessor to ASC 842), operating leases were not recorded on the balance sheet. In practice, operating leases appeared in the footnotes of the financial statements, while capital leases were reported on the balance sheet. Many companies also chose to not evaluate leases embedded in service agreements. The moving of operating leases to reporting on the balance sheet results in the elimination of one more form of off-balance sheet obligation.

Under the new guidance, a lease is defined as a contract that gives a customer the right to control the use of an identified asset for a period of time in exchange for consideration. Once a lease is identified, it is classified either as a finance lease or an operating lease. Then, it must be capitalized on the balance sheet by adding a liability and a corresponding right-of-use (ROU) asset by discounting future lease payments using the rate implicit in the lease or an incremental borrowing rate.

Transparency and the Office Space Example

For anyone who is reading this in their office, chances are that your office space rental has historically been classified as an operating lease in your company’s audited financial reports. These are very common, long-term obligations employed by businesses of all sizes, that have historically been reported off-balance sheet. The new standard results in the capitalization of the future rental payments on the balance sheet. Thus, comparing financial statements from one business to another is enhanced as both balance sheets now display the capitalized leases, showing the present value of lease payments, previously only mentioned in a footnote.

The New Global Standard: FASB and IASB

Although FASB and IASB joined forces to develop a new accounting standard, the two boards did not converge on a single accounting standard due to certain key differences between ASC 842 and IFRS 16. The most noticeable departure between the two standards is found in how the income statement is affected.

ASC 842 maintains the dual model approach for lease classification, bifurcating them among operating and finance leases (formerly, capital leases). The main difference between the two lease categories is that a finance lease transfers both the risks and benefits of ownership from the lessor to the lessee, for a significant portion of the asset’s life. Alternatively, an operating lease only transfers the right to use the property to the lessee. However, IFRS 16 does not make a distinction and requires a single model, whereby all leases are treated as finance leases.

Finance leases recognize expense in the income statement differently than operating leases. An operating lease expense is a single straight-line operating expense item, whereas a finance lease recognizes both an interest expense and a depreciation expense as separate line items. The finance lease classifications of expenses cause there to be a movement of a portion of the expense below the operating income line, which ultimately increases EBITDA for companies that employ a classified income statement. In other words, the total lease expense for a finance lease will be higher at the beginning of the lease period and lower at the end of the lease period compared to an operating lease which is a straight line expense.

Other differences exist as well; therefore, it is important that companies reporting under both standards familiarize themselves with the long list of diversions between US GAAP and IFRS.

Meeting the Lease Definition Criteria

It is important to understand the conditions that a commitment must meet to count as a lease because this will have a direct effect on the balance sheet. For example, operating leases will not have to be capitalized if they are shorter than 12 months in the term of commitment. As mentioned previously, a lease is a contract that conveys the right to control the use of an identified asset for a period of time in exchange for consideration. Below, we focus on the control and identified asset criteria and discuss some examples where both requirements might be tested.

Criterion 1: Control

Control of an identified asset is considered to exist if the customer has (i) the right to obtain substantially all of the economic benefits from the use of the asset and (ii) the right to direct the use of that asset. The numeric threshold to meet the “substantially all” requirement is not stated in FASB’s guidance. However, practitioners have agreed that 90% or more of an asset’s capacity generally provides “substantially all” of that asset’s economic benefits.

Criterion 2: Identified Asset

An asset must be explicitly or implicitly identified in the contract. This can be accomplished by outlining a specific physically distinct portion of a larger asset in the contract. Physical distinctness is different than capacity; and, the specified capacity portion of an asset does not result in an identified asset unless it represents “substantially all” of the capacity of the asset.

Storage and Transportation Commitments: A Primer

Companies that engage in the marketing and trading of energy products and other physical commodities are very familiar with a specific group of commitments related to storage and transportation contracts. Energy traders typically acquire transportation through contracts with pipeline operators or railroads and storage capacity, through contracts with terminals and storage operators, in exchange for monthly payments, which may have a minimum floor as well as fees based on volume and/or capacity utilized. Storage and transportation contracts equip energy marketing companies and traders with the ability to transform physical commodities in time (storage), space (transportation) and quality (blending). Traders may also enter into processing contracts which give them the rationale to transform the physical form of physical commodities. The transformation in time, space and form is accomplished in a variety of different ways, such as by moving product from a location of excess supply to a location where supply is more scarce via pipeline or rail. Alternatively, storage contracts allow traders to acquire inventory when seasonal demand is low in anticipation of rising demand, often driven by weather, in the future. The accumulation of heating oil in the spring and summer in anticipation of rising demand in the winter exemplifies this trading strategy. With the accounting standards changing, many companies are focused on whether previously off-balance sheet storage and transportation commitments will now have to come onto the balance sheet.

There are various circumstances that may either qualify or disqualify these contracts from having to be capitalized on the balance sheet; this all hinges on the two lease defining criteria outlined earlier.

For example, in the case of a contract for the right to use a pipeline to transport crude oil, the contract may not include a specified asset even if the percentage of that pipeline’s capacity is outlined in the contract. Pipeline assets often lend themselves to be used by more than one party. Unless the contract gives the customer the right to use “substantially all” of that pipeline’s capacity, then the asset would not meet the identified asset and control criteria.

Similarly, midstream energy companies could also make use of a multi-year contract to use a railcar to transport bulk liquid products, such as crude oil or natural gas liquids (NGLs). In this case, the asset (the railcar) may be implicitly specified if the contract stipulates that the railcar used must meet certain prerequisites to transport the commodity. However, the “identified asset” criterion may not be met if the lessor has substantive substitution rights, whereby the lessor has the practical ability to substitute the rail car with another one.

In both of these examples, if they did not meet FASB’s definition of a lease, then they would not have to be capitalized on the balance sheet. Therefore, each arrangement must be carefully analyzed on a case by case basis before determining if it meets the criteria of a lease.

Financial Statement Effects and Debt Covenants

The forecasted increase in liabilities as a result of ASC 842 and IFRS 16 has been widely reported, with the IFRS Foundation publishing a study that estimated a $2.2 trillion increase for public companies. In September 2019, Bloomberg wrote about WeWork’s $47 billion in undiscounted operating lease commitments.² After WeWork became an early adopter of the new lease accounting standard, these commitments began to be reported on the balance sheet and increased total liabilities by the present value of $18 billion. The newly capitalized leases more than tripled WeWork’s total balance sheet liabilities. The effects of ASC 842 are likely to be less pronounced for most companies; however, a tangible effect will undoubtedly be experienced on most companies’ balance sheets.

Companies using debt finance generally must abide by financial covenants present in their indentures or credit agreements. These covenants often come in the form of financial ratios calculated using figures taken from the financial statements. Any ratio that is calculated as a function of assets and liabilities would likely be affected by the new standard. Given that lease capitalization affects both total assets and liabilities equally, the net effect on equity would generally be close to zero. Capitalized operating lease obligations don’t fall under the definition of debt, so finance covenants tied to a rigid definition of indebtedness are unlikely to be breached. However, many covenants take a more all-encompassing approach to defining indebtedness that includes other items classified as liabilities; these types of covenants could be affected.

The way that operating lease expenses flow through the income statement remains unchanged for companies reporting under GAAP, so the new standard will have little impact on measurements based on this statement, such as reported earnings and EBITDA. However, under IFRS, as all leases are finance leases, there is generally a higher expense at the beginning of the lease period. The new standard may also add significant volatility to income statements in the form of foreign currency denominated leases as the lease liability gets remeasured using current FX rates, whereas the asset is pegged at the historical rate. For some companies, this mismatch affects equity directly, and for others, it runs through the P&L. Each case depends on how subsidiaries are structured and what the functional currency is.

Given the way the standard is impacting financial statement items that are used in the calculation of financial covenants, it will be important for borrowers and lenders to update their definitions and covenant guidelines to adjust for higher assets, liabilities and potential changes to the EBITDA calculation.

Private Companies Get the Last Word

The new leasing standard requires all companies to capitalize operating leases that are within the scope of the definition of a lease and not subject to exemptions. Given the many changes of the new standard, companies have voiced their concern with respect to the operational burden that has been created. The American Institute of Certified Public Accountants (AICPA) even requested that FASB delay the effective date of ASC 842 for private companies. The new standard became effective in early 2019 for public companies. Under the original effective date, private companies had until 2020 to become compliant with the new standard, which was later extended.

For many companies, the main operational challenge has been to identify the population of all leases that exist throughout their organization. This includes reviewing all contracts for any embedded leases that may lie within. In essence, moving operating leases onto the balance sheet has created added scrutiny to the final number presented, necessitating the successful implementation of a system that ensures data accuracy and quality. The most laborious undertakings have been to implement this new system, which captures all lease data in a centralized database and ensures that the system produces correct accounting results.

As companies seek to comply with ASC 842, they have also experienced challenges related to accounting policy. For example, the appropriate discount rate used to discount lease payments can be difficult to determine. Since the rate implicit in a lease is usually not known, many companies have elected to use an incremental borrowing rate (IBR). The IBR is defined as the rate of interest that a lessee would have to pay to borrow (a) on a collateralized basis, (b) over a similar term and (c) an amount equal to the lease payments in a similar economic environment. However, it is not always clear what the IBR should be without seeking help from valuation specialists to obtain appropriate data points.

After listening to the concerns voiced by AICPA, on October 16, 2019, FASB pushed back the effective date for private companies by another year, to the fiscal year beginning on January 1, 2021 for calendar-year-companies. This is great news for private companies given the amount of leg work that is required to enact the change in companies’ respective financial reporting.