Doug Houser: From Rea & Associates Studio, this is unsuitable, a management and financial services podcast for entrepreneurs, tenured business leaders, and others who are ready to look beyond the suit-and-tie culture for meaningful, measurable results. I'm Doug Houser. On this weekly podcast, thought leaders and business professionals break down complicated and mundane topics and give you the tips and insight you actually need to grow your business. If you haven't already, hit the subscribe button so you don't miss future episodes. And if you want access to even more information, show notes, and exclusive content, visit our website at www.reacpa.com/podcast and sign up for updates. In less than a year, private companies will be required to adopt the new accounting standard for leases. This means those who follow generally accepted accounting principles and carry leases are in for some pretty big changes. Jim Suttie, a principle on Rea's lease accounting taskforce, is here to provide some much needed insight into what this new standard means and how to start preparing. Welcome to unsuitable, Jim. Jim Suttie: Thanks, Doug. Doug: Thanks for being on today. I know we got a little reprieve with the lease accounting standard, right? It was pushed back due to COVID in terms of the implementation for private companies. Now, as I understand it, correct, though, we are going to go live for any fiscal year that ends after 12/15/21, it's required. Is that correct? Jim: It's for years beginning after 12/15/21, so essentially for 2022, if you're a calendar year. And there have been many reprieves. So the Financial Accounting Standards Board, or FASB as most of us in the profession call, has been threatening to do this for a little over 10 years now. They started this talk back in 2010, believe it or not, as sort of a... I call it harmonic convergence with international standards. And yes, as you said, we got a reprieve for a couple of different reasons. One was COVID. Two was they had come out with a couple of other significant changes in standards, one being revenue recognition, and so companies were... We had pushback from a lot of companies that said, "We can't implement these all at the same time. Can we push one of them back?" And leases was the lucky winner and got pushed back another year. Doug: Yeah. And it's also been already implemented for publicly traded companies for a couple of years now, so there was some additional chance to see the impact and what it did in terms of reporting and all of that as it relates to public companies, right? Jim: Right. We've seen some not-so-pleasant feedback from public companies, or some of them anyway, meaning that it has been a lot more expensive. There's a lot more time consumed in accounting for leases under this new standard. So private companies are going to have even more fun, because in many cases they lack the, I'll say, sophistication of a public company, or even personnel that a public company would have. Doug: Right. And so let's talk about the genesis of this. I mean, initially, the driver of this was sort of to recognize these, quote-unquote, "off-balance sheet liabilities," and try to get some clarity around those obligations. Was that sort of the genesis of what we were trying to do here? Jim: Yes. So under the current standards, there are two different types of leases. One is a capital lease, and one is an operating lease. So capital leases under the current standard are already recognized on the balance sheet as liabilities. The ones that have not been recognized as liabilities are operating leases. So those operating leases... And the thought process behind that is, it's an obligation of an entity. So if I'm locked in to make payments for a certain amount of time, the FASB concept would say that, "Well, that's really a liability, and it should be reported on the balance sheet." Doug: Yeah. And at this point right now, of course we disclose those typically with a footnote disclosure, but thought being, "Hey..." I know at least with a large number of publicly traded companies, there was always a big push to, to get those off-balance sheet and make those operating leases rather than capital leases, where they weren't recognized. It certainly impacts financial ratios and all those things, which we'll get into. But for your typical owner-managed, privately held business that's our client base and who we deal with and our audience here, what does this mean to them? I mean, they look at it like, "Well, okay, how is this any different? Yeah, I already know I have these obligations. Now you're telling me, okay, I've got to recognize them on my financials. But who cares? Why should I care, if I'm just a privately held business, right?" Jim: You should care, because it is going to have a significant impact, and in particular on your balance sheet with operating leases, because what it will do is, you'll be required... Again, if this is under GAAP, or general accepted accounting principles, you'll be required to book a liability for the future payment stream of an operating lease. And that future payment stream includes what you're locked in for already as well as likely options to extend. Often you have leases where you'll have an option to renew a lease, and so those likely extension options are also included in the determination of the payment stream, and in turn the determination of the liability that's going to go on the balance sheet. Doug: Yeah. There's this concept that we really have to look at as a right-of-use asset, correct? That's the term. So talk a little bit about what that means when I say, "Okay, right-of-use asset," and trying to recognize that. Jim: Sure. Once I book the liability, for every credit, there's got to be a debit. So that debit is this right-of-use asset that you mentioned, Doug. And a right-of-use asset is basically, I have the right to use a specific asset over the term of that lease. So that is what this, quote unquote, "right-of-use" asset is. Doug: Yeah. And then you've got some people trying to think ahead. I know I've heard this in a few different construction industry meetings. "Okay, well, what if I just enter into, say, an 11-month lease or something for my building? But even though the, quote unquote or wink wink, 'intent,' is I'm probably going to stay here longer, but we're just going to sign 11-month lease." So there's some things I know people have talked about to try to get around it, but really you can't, because then you look at it like, well, is their intent really to leave that building in 11 months? Probably not. So you can't necessarily game the system that way. Is that correct? Jim: Sure. There are varying schools of thought, and I don't know that anybody really has nailed it down. A couple of different concepts here, Doug. One, if you have a true short-term lease, those do not need to be booked on the balance sheet. So 12 months or less, if it's truly a short term and I'm only going to lease an asset for 12 months, I don't need to put a liability on my balance sheet. The other thing that you had referred to is, oftentimes entities will set up, for example, a real estate entity, and so the operating company will lease its facilities from the real estate entity. And oftentimes, again, they either have a month-to-month lease or no lease agreement at all. And so what we're looking at here is form over substance. And so the substance is, well, yeah, I might have a month-to-month lease, but I'm probably going to stay in my own building for more than a year. So there's some of the art and science involved in this, in figuring out, okay, well how long do I really intend to stay in this building? What is the economic life of that building? Like I said, there's some artwork to this. So you really have to determine what your true intent is in that scenario. Doug: Yeah. As you said, it's certainly different if I lease a piece of equipment for a month and with the full intent I'm going to use it on a job or whatever and turn it back in. I mean, that's fine. No issue with something like that. It's obviously easily identified and all of that. But you've got this other concept too of embedded leases that could be contained within other agreements, and it's a fair amount of work to try to really go through those and glean, okay, what's a lease? What's not? Where do we have to take a look at things? So talk a little bit about some of those examples [crosstalk 00:10:34]. Jim: Sure. You may have a service contract and, as you mentioned, embedded leases, so a document does not have to say "lease" at the top of it in order to be a lease under this standard. So it is going to take some analysis to determine what truly is a lease, and it may or may not be called a lease, but, again, we're talking about form over substance. So in reality, companies may be surprised that they have more leases than they initially thought. Doug: Yeah. For example, I think of companies... Maybe they have a fleet of vehicles that they use for employees or things like that, that typically they've not recognized, because they've turned those over, or they've been operating leases, or, as you said, maybe under some service type of agreement, but really, in essence, if you look at the form, they may in fact qualify under this right-of-use asset. Jim: Yeah. That's a great example, Doug, the vehicles. If I'm locked into a vehicle lease for, let's say, three years, I really do have a right-of-use asset there, and I have a liability. So again, that may be a surprise to some people. "Oh my gosh, I've got to put this on my balance sheet now," where previously it was just kind of disclosed... Not kind of. It was disclosed in the notes to financial statements, "I've got this lease commitment," but it wasn't really stated as a true liability, whereas now under the new standard it will be. Doug: And that's a thing too that we're seeing. So if you think about it from an accounting perspective, as you mentioned, you put the asset on the books, you put the liability on the books. So the thing that it can do, however, is throw off, say, a debt-to-worth measurement, because all of a sudden now your debt is higher and your net worth hasn't changed. It can also impact debt service coverage and some of these financial covenants. And for most privately held companies, I know in my... Go back to my banking career as well. I mean, it's not something that was really always that closely paid attention to in terms of the specific definitions therein, but you've got to really be careful with this, right? Jim: Sure. And there may be even restrictions on new asset purchases within a financing agreement. Doug: Good point, yeah. Jim: [crosstalk 00:13:17] a debt agreement. And so are bank's going to consider this an acquisition, asset acquisition, that throws somebody into a covenant violation? So that's why it's important, I think, for companies to have conversations early, and it's getting late-early around here, because we're getting close to implementing this. And so I think most banks, I would hope anyway, at least the ones I've talked to, they're aware of the standard but may not be fully aware of all of the impacts it may have. You mentioned certain ratios. Again, current ratios where you've got... You book a liability. Part of that is current. Well, you don't have a current asset to offset that. You've got to write a use asset which is not current. I think I saw an article the other day, a lot of gotcha moments. And so I think there will be some surprises. So it's going to take a significant amount of effort in some cases to make sure that these are accounted for correctly. Doug: Yeah, that's the thing. We want to make sure, again, you get us involved, you get your CPA involved, get your bank involved, and start thinking about, "Okay, what's the potential impact? And can we amend the agreements such that we're not having any unintended consequences?" Because I think that's what we want to obviously avoid here. Jimmy talked a little bit about some of what public companies have seen in terms of cost and going through and trying to understand and categorize all this stuff. What are we doing as a firm? Are we investing in software to help us analyze this? What are some of the initiatives that you're seeing as part of our task force? Jim: Yes. We have contracted with a company to use their software, and it's a cloud-based solution, and it is accessible by both our clients and us. So some clients may have a level of sophistication that would allow them to be able to do this on their own. And this software is very user-friendly. I don't know if I'm allowed to use the name or not, but it will calculate the lease liability and calculate at least the numeric disclosures for the lease agreements. Doug: That's awesome, yeah. So it simplifies that process rather than trying to essentially manually analyze all of these [crosstalk 00:16:06]. Jim: Right. And that software also has gone through a service organization controls [inaudible 00:16:16] audit, but it's an audit, as well as being tested thoroughly. So it's much more beneficial, this is my opinion, to use a software like that, as opposed to using an Excel spreadsheet, which has more potential for human error or input error. Doug: Sure. Yeah. So it's, I think, incumbent, once you get started with this process, do it right up front, because that will make it more efficient and decrease your costs in the long run if you obviously keep this up and do it year after year and deal with your acquisitions and dispositions and all of those things. So you don't want to make a mess of it before you get started, in other words. We've seen that too many times, right? Jim: Far too many. Doug: Yeah. So if you're in the shoes of an owner of a company, what should they be doing now to start thinking about this? So it's going to be, in essence, effective for them next year, but you want to take some steps before then. You don't want to wait, correct? Jim: Right. You certainly don't want to wait, certainly not any longer. So get an inventory of certainly your lease agreements and other agreements that you think might have a lease component or non-lease component. Talk with your CPA. Talk with your lenders to make sure that they understand the potential impact this may have on your financial statements. This is going to take some work. Now, everything under generally accepted accounting principles is subject to a materiality threshold, so there may be many things that fall under that materiality threshold, like a coffee maker that technically is a lease or a service contract. You may have copiers that fall below that materiality threshold. But all those things need to be taken into consideration. So again, you need to start now, talking, again, with lenders, and most definitely with your CPA, because everybody's going to need to be involved and be on the same page in order to analyze agreements. And, as you said, do it right from the start as opposed to having to go back and fix things. Doug: Yeah, absolutely. And it's something to think about too even if you're not required to provide a review or an audit to a third party. Still many of those third-party financial disclosures require that you provide financial statements that are in accordance with GAAP. So even if those are internal numbers or whatever the case might be, you'll want to be on top of this. So again, important to understand all of those agreements and what your requirements are. Jim: And you may see, just as an aside, you might see people adopting other financial reporting frameworks to get out of this. That's probably a harsh term to say, get out of it, but to maybe avoid some of those hassles and avoid some of the cost of doing this. Doug: Yeah. It will be interesting to see what some of the other third parties require in terms of that as we move forward. I would suspect they'll still want that presented. I know when you do a lot of that financial analysis, they would include those operating lease payments anyway in doing cash flow analysis and all those things. So in some ways it ultimately gets us, I think, more transparency and clarity, makes it easier, but there's just a period of adjustment, like with anything. Jim: Agreed. And, Doug, you know, being in the banking world for a while, most of those agreements say GAAP, whether or not a... no offense intended, but whether or not a banker knows really knows what GAAP means. I know they know what GAAP means, but if they know the impact of that. You may see from time to time banks might... And I've seen it before. They have accepted some other reporting framework other than GAAP. It can happen. Doug: Yeah. It's rare, but yeah, we'll see. Well, thanks, Jim. It's great to improve our understanding of this upcoming change in terms of lease accounting standard. And I'm sure we'll be hearing more and certainly getting more information out to our client base. And as always, feel free to reach out to our experts like Jim with any questions. So thanks for being on with us. Jim: Thank you. Doug: Absolutely. And if you want more business tips and insight or to hear previous episodes of unsuitable, please visit our podcast page at www.reacpa.com/podcast. And while you're there, sign up for exclusive content and show notes. Thanks for listening to this week's show. Be sure to subscribe to unsuitable on Apple Podcasts, Google Podcasts, wherever you're listening to us right now, including YouTube. I'm Doug Houser. Join us next week for another unsuitable interview from an industry professional.
