On February 25, 2016, the Financial Accounting Standards Board (“FASB”) recently released its much-anticipated lease accounting standard, ASU 2016-02, Leases (Topic 842). While the ASU will probably not have a direct effect on the financial statements of a private equity fund, it may have a significant impact on the financial statements of the underlying portfolio company investments that the private equity fund holds.
The genesis of this standard was born approximately 15 years or so ago with the 2001 collapse of Enron. At that point in time, regulators became very concerned with “off-balance sheet” financial obligations that were a major contributor to the Enron accounting scandal. In 2005, the U.S. Securities and Exchange Commission (“SEC”) issued a report on off-balance sheet activities that recommended changes be made to the existing lease accounting requirements to ensure greater transparency in financial reporting. In 2006, the FASB and the International Accounting Standards Board (“IASB”) started a joint project to improve the financial reporting of leasing activities. This guidance responds to the requests of financial statement users for greater transparency of an enterprise’s leasing activities; it also ends what the SEC has identified as one of the largest forms of off-balance sheet accounting. It is estimated that almost $3 trillion of lease-related assets and liabilities will be recognized on the balance sheets of public companies around the world according to a joint analysis performed by the FASB and IASB as a result of the standard.
Under the standard, a substantial number of leases (except those that meet the definition of a short-term lease) will be recognized by lessees on the balance sheet through a right-of-use asset and corresponding lease liability. Prior to this guidance, portfolio companies that report under US generally accepted accounting principles were required to recognize capital leases with an asset and liability on the balance sheet, while only disclosing future obligations resulting from operating leases. On the income statement, a dual model is being used, requiring leases to be classified as either operating or finance. Operating leases will require straight-line expense treatment (similar to the current treatment of operating leases), while finance leases will require front-loaded expense treatment (similar to the current treatment of capital leases). Classification will be based on criteria that are similar to those applied in current lease accounting.
The guidance also requires additional financial statement disclosures to help financial statement users get a better grasp on the amount and timing of cash flows generated from leasing activities. Extensive quantitative and qualitative disclosures will be required, including any significant judgements made by management, to provide transparency into the extent of revenue and expense being recognized or expected to be recognized as a result of leasing arrangements.
For portfolio companies which are public business entities, the standard is effective for annual periods beginning after December 15, 2018 (i.e., calendar periods beginning after January 1, 2019), and interim periods within those fiscal years. For all other entities, the standard is effective for annual periods beginning after December 15, 2019 (i.e., calendar periods beginning after January 1, 2020), and interim periods after December 15, 2020. Early adoption would be permitted for all entities. Transition to the new standard will require the application of the new standard at the beginning of the earliest comparative period presented.
Although management companies and portfolio companies have nearly three years (or more) before the effective date of the standard, efforts at implementation should not be delayed. While the reporting changes will not directly affect how business is conducted, the changes will have a significant internal impact on the financial reporting of a management company and portfolio company. Management companies and portfolio companies will need to take an inventory of existing lease arrangements and other contractual agreements in order to be in compliance with the new standard. Leases may be embedded in some service arrangements or provided alongside other goods and services, making this step of gathering complete and accurate data complex and time consuming. Modification to a management company or portfolio company’s existing systems or processes may be required. Also, of significant importance is the potential effect beyond financial reporting; borrowing base calculations, loan covenants, debt to equity ratios, compensation arrangements, and apportionment of income for state tax purposes are just a few of the items which can potentially be adversely affected by the implementation of the guidance. In addition, management companies and portfolio companies should now consider this new standard when entering into any new lease arrangements going forward, as any leasing arrangement entered into will now require recognition on each entity’s respective balance sheet. It is also anticipated by some “C-level” executives that this guidance will make it more difficult to obtain debt financing for their companies.
At the investment partnership level, this new standard may change how investment managers are valuing their underlying portfolio companies. To mention a few considerations, certain financial ratios such as return on assets and debt-to-equity will be directly affected. The new “debt-equivalent liabilities” will need to be considered when determining the true financial risk of an underlying portfolio company. The ability of a portfolio company to meet its loan covenants based on an inflated balance sheet will also need to be considered.
There is time, and there are options to potentially reduce the impact of the implementation of the new standard. The ASU offers relief from implementing the standard’s transition provisions by permitting an entity to elect not to reassess certain criteria of existing or expired leases. In addition, short-term leases as defined in the guidance are exempt from recognition on the balance sheet. Lastly, an entity’s judgment in distinguishing between leases and services becomes critical in assessing whether or not to apply the new standard. Management of portfolio companies and any investment manager sponsors should use this time to review their lease portfolios and consider the potential balance sheet impact.
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