So-called embedded leases may not be the first thing you think of when considering the effects of ASU 2016-02 under the new FASB standard for lease accounting. But this much-anticipated new rule can provide a forcing mechanism for how your business treats leases tied to service contracts.
When I discuss the new accounting standard with ratings agencies and others, they noted that they had previously used analytical tools and benchmarks to determine the effect operating leases have on organizations’ financial results. Effectively, they were already modeling liability into the balance sheet.
In fact, a July 17 article in Modern Healthcare reported that rating agencies have generally said this new rule won’t necessarily move the dial on companies’ creditworthiness.
In my opinion, however, there’s a catch. The modeling technique could fail to consider the effect of embedded leases.
In my opinion, however, there’s a catch. The modeling technique could fail to consider the effect of embedded leases. To be fair, it would be almost impossible for ratings agencies to model in their effect; due to the quid pro quo nature of these leases, their impact is not easily quantified. Take the case of dispensing machines in hospitals. A supplier provides a dispensing machine for pharmaceuticals and supplies for free; however, under the agreement, that supplier requires the hospital to buy all of its pharmaceuticals and supplies from that specific vendor. The price of those products includes the embedded lease payments, which are difficult to separate out in a model. Another complicating factor with modeling: no two organizations have the same strategy around leasing.
Varying impact on the balance sheet
Companies have begun disclosing results based on the new standard. Tenet Health Care (Ticker: THC), the for-profit health care provider, noted in its first-quarter results that it recognized $822 million of a right-to-use asset, net of deferred rent, under ASU 2016-02. But it also recognized total liabilities of $862 million: $147 million of current liabilities and $715 million of long-term liabilities associated with operating leases.
Welltower (Ticker: WELL), the real estate investment trust, said in its first-quarter filing that the effect ASU 2016-02 adoption was the recognition of a right-of-use asset of $509.4 million and operating lease liabilities of $357.1 million.
Below are some data points of a few of the publicly traded organizations (source: companies’ 2019 Q1-10Qs and 2018 10-Ks).
The takeaway here? Do not overlook embedded leases under the new FASB lease accounting standard; the effect on your balance sheet may surprise you, as well as key company stakeholders.