CHANGES IN LEASE ACCOUNTING AND WHAT PROVIDERS NEED TO KNOW

Transcription

1 GLOBAL CONSTRUCTION CHANGES IN LEASE ACCOUNTING AND WHAT PROVIDERS NEED TO KNOW Sharon Carter Recognizing lease assets and lease liabilities on the balance sheet, and disclosing key information about leasing transactions, will increase transparency and comparability among healthcare providers. All leases, both operational and financial, need a periodic review to clearly determine which lease options to renew, terminate, or purchase. Healthcare providers often enter into lease agreements to secure the latest and greatest in medical and technology equipment, and real estate. Leased materials often represent a sizable portion of these entities physical assets. Although the road to financial reporting of leases is intended to be transparent, it is not without a few bumps and a fork in the road. It has been two years since the Financial Accounting Standards Board (FASB) issued its final standard (ASC Topic 842), related to lease accounting protocols. Established in 1973, the FASB, an independent, privatesector, not-for-profit organization based in Norwalk, Conn., develops and issues financial accounting standards to promote useful financial reporting information to investors and others, such as public and private companies and not-forprofit organizations that follow generally accepted accounting principles (GAAP). The FASB is recognized by the Securities and Exchange Commission as the designated accounting standard setter for public companies. 1 LEASING OR OWNING MEDICAL EQUIPMENT When directly purchasing a piece of equipment with capital, hospitals own the equipment and can depreciate the cost of the asset throughout its useful life. If the equipment is financed, tax filings allow interest deductions. However, we are in the age of technology disruption and medical equipment s useful life should not be overstated. For instance, a typical magnetic resonance imaging (MRI) scanner costs approximately $1.5 million, but may need to be replaced with more technologically advanced models. The investment is a significant outlay of cash, and comes with associated expenses, shielding containment, radio frequency, certification, and other elements. 1. Financial Accounting Standards Board, About the FASB.

2 The alternative to outright owning medical equipment is the budget-friendly option of leasing. Leasing medical equipment offers a competitive advantage for healthcare practices to have the latest in medical advances and trade up to the latest models. There is a further benefit to leasing equipment by maintaining a steady cash cost to the hospital by spreading otherwise variable costs such as startup, down payments, and full costs over a known period. Traditionally, lease payments are a deductible expense, offering a capped annual tax savings that could be significant. LEASING OR OWNING REAL ESTATE Healthcare reform has healthcare executives scrambling to map out strategic visions to sustain the continuum of care on campuses and be disciplined with fostering current and new market share growth. Models of care will continue to engage in the objective of: Right care Right place Right time Right cost Right debt liability Healthcare real estate continues to be primarily hospital-owned. According to a 2013 review by Revistamed.com, three healthcare providers had the top positions in the healthcare real estate market with Kaiser Permanente at $26.8 billion, Ascension Health Alliance at $18.0 billion, and Hospital Corporation of America at $18.5 billion. 2 Billions $400 $380 $360 $340 $320 $300 $267.5 $280 $260 $240 $220 $ Growth in total Healthcare Real Estate Assets Top 50 Owners of Medical Real Estate $297.5 $331.5 $ Source: Revista and Revistamed.com 2. John B. Mugford, Top 50 Owners of Medical Real Estate, Healthcare Real Estate Insights, September 25,

3 Healthcare providers have a strong preference to own facilities that house a core mix of services for their patients. In the Houston market, for instance, Houston Methodist continues to bring convenience and care to patients in locations around the greater Houston market, notes Sid Sanders, Houston Methodist, SeniorVice President, Construction, Facilities Design and Real Estate, We continue to move forward with our plan to build a facility platform designed to best serve our patients. As part of that plan we opened a 193 bed multi-specialty acute care hospital last June in the Woodlands and will open a 366 bed replacement and expansion tower in the Texas Medical Center this Summer. We are also building a distributed network of primary care and specialty care clinics as well as expanding and renovating our existing acute care platforms as warranted to meet the needs of our patient population. While large capital moves such as these are infrequent, they are still an important strategic part of our capital plan. Owning healthcare real estate requires an intentional strategy and recognition of the accounting treatment for capital and operating leases. The differences can have significant impact on taxes owed by the provider. It is important to understand the definition of current accounting rules in order to implement the ensuing changes to accounting methods. An alternative to a provider owning real estate assets, is a strategy to preserve capital and long-term flexibility. The objective Right Care, Right Place, Right Time, and Right Cost, takes capital and may require leveraging third-party capital to attain speed to market, reduce risk of a real estate asset, and create a predictive cost of rent. Leasing versus owning will increase project/strategic investments, and improve return on investment and internal rate of returns. Benefits to the hospital or healthcare system are leasehold rights to the facility for 10 to 20 years. Branding is transparent and the provider continues to preserve capital for the use of electronic health records, physician recruitment, the latest in technology, and key initiatives to support patient care. Partly due to the Patient Protection and Affordable Care Act of 2010 and the Health Care Education and Reconciliation Act, released the same year, some previous leasing practices changed. Prior to 2010 it was not uncommon for some of the leased facilities to be owned by physician groups that referred patients to the leaseholder. The mandates reflected in the Stark Law, made it illegal for healthcare providers to submit claims for federal Medicare or Medicaid reimbursement for services provided to patients if the patients were referred by physicians who had a financial relationship with the provider, thus eliminating conflicts of interest and possibly reducing quality of patient care outcomes. To mitigate hospital risks of owning real estate, providers began to lease space from third-party entities, and remained cautious: Ensuring lease agreements were made specific to its use. Confirming lease agreements were properly authorized. Making sure leases were up-to-date with no lapse in time. Ensuring rents negotiated and paid at fair market value. Reinforcing and monitoring to compliance standards of use. Monetizing physician-owned properties when acquiring physician groups. ACCOUNTING METHODS FOR LEASES Operating Lease A majority of leases are operating leases. An operating lease is treated like rent payments are considered operational expenses and the asset being leased stays off the balance sheet, and thus the corresponding debt liability does not have to be calculated or included. Operating leases provide muchneeded flexibility as updates and replacement of equipment are expected, and typically come with a protection of obsolescence in the lease agreement. The highest benefit is that lease payments are operational expenses and are fully tax deductible. This provides an improved return on asset without capital budget restraints. Under current FASB rules, long-term leases for real estate assets are classified as operating leases. Operating leases typically don t impact the balance sheet of the lessee. Healthcare providers have been able to classify long-term leases for healthcare facilities as operating leases. Existing rules have allowed providers to monetize noncore assets like medical office buildings through sale-leaseback arrangements with little impact on their balance sheet. Capital Lease In contrast, a capital lease is more like a loan or debt the asset is treated as being owned by the lessee so it stays on the balance sheet. Capital leases recognize certain expenses sooner than operating leases: the lessee is allowed to claim depreciation each year on the asset. In addition, the interest expense component of the lease payment can also be deducted as an operational expense. 3

4 EARLY ADOPTERS It has been two years since the FASB issued its final standard (ASC Topic 842), which delineates the changes that will be made to lease accounting. The new FASB Lease Accounting Changes, FAS 13 and IAS 17, updated in January 2018, will take effect in January 2019 for public entities, and in January 2020 for all other entities. 3 Proposed changes would virtually eliminate operating lease accounting treatment for providers that lease real estate, and require assets and liabilities to be reported similarly to capital or finance leases. But there are some differences in how these assets and liabilities are measured. To meet the multifaceted challenges of disruption to financial accounting rules, the healthcare industry must re-examine their current lease practices and answer some tough questions: Own or lease? How long to lease? Determination of asset or liability to the balance sheet. Operating Lease? Impact on income statement? Profit and loss results? Answers to these questions will no doubt create a cumbersome network of required reviews and take time. The accounting change will make lease management and accounting more complex. The new accounting model will require sophisticated financial calculations and will mandate more monitoring and tracking of lease details throughout the life of a lease. WHERE DOES A PROVIDER BEGIN? It is no wonder that some providers have become early adopters, initiating a thorough filtering of their equipment and real estate leases well before the deadlines. With the exception of shortterm leases (term of 12 months or less), real estate leases will be treated as capital/finance leases. It is imperative that all other leases should be reviewed and tagged for either a lease renewal, lease termination, or right to purchase. Capital lease/finance lease? When evaluating lease vs. own, the impact on key financial ratios and credit rating should be considered = profitability/ operating margin, debt position (cushion ratio, long-term debt/cap) and liquidity (days cash on hand), and cash to long-term debt). Consider impact on debt capacity and answer the question, Can the cash be invested to generate a higher return than the lease expense? It may be that a lessor may have already been approached by the lessee to reduce their lease term to less than 12 months. Reporting leases with these terms are given an exemption as a debt liability. 11-Month Lease The objective of financial reporting is to increase transparency and comparability among organizations by recognizing lease assets and recognizing lease liabilities on the balance sheet, and provide information that is useful to current and potential investors, creditors, donors, and other capital market participants. It is imperative that confirmation of rational investments be made, as they impact credit and similar resource allocation decisions. The good news is that there are many benefits to leasing, despite the lease accounting changes: Maintain Cash Flow Preserve Capital Obtain Flexible Financing 3. FASB. Accounting Standards Update. 4

5 To fully leverage lease accounting changes, the healthcare provider the lessee must focus on responses that result in the maximization of the provider s bottom line. The lessor, however, will also be affected. Lessor Impacts Lessor accounting remains essentially unchanged; according to the FASB, a majority of operating leases should remain classified as operating leases, and lessors should continue to recognize lease income for those leases on a straight-line basis over the term of the lease. For an arrangement to be a lease, or to contain an embedded lease, it must convey to the provider the right to control the use of the asset for a period of time, in exchange for approved lease consideration. For an arrangement to be a lease, or to contain an embedded lease, it should convey to the provider the right to control the use of a real estate asset and equipment for a period of time in exchange for approved lease consideration. The implementation of FASB (ASC Topic 842) will require real estate lessors to use operating lease accounting methods and recognize depreciation of an operating lease on a straight-line basis, or accounts receivable residual approach to front-load lease expenses, all determined under current GAAP. 4 UNDERSTANDING CURRENT STATE AND FUTURE STATE With respect to expense recognition, the FASB classifies leases in two categories operating and financing with many equipment leases falling into the financing category and most real estate leases falling into the operating category. 5 CURRENT STATE Risk-Reward Approach: Distinguishes between an operating lease and a capital lease. Present Value: Rent recorded as an expense if provider did not own the asset (i.e., real estate). FUTURE STATE Right-of-Use Approach: Lessee to account for each equipment lease contract s rights and obligations as assets and liabilities. Present Value: Providers/lessees to record the present value of the lease rent as an asset and liability. Equipment Leases: Expenses related to equipment leases would be recognized as interest. Equipment Leases: Depending upon how much of the leased item is consumed during the term of the lease, expenses related to equipment leases would be considered financing contracts. Short-Term Leases: No change. Long-Term Leases: Long-term operating leases will appear on the balance sheet as nondebt liabilities. Leverage Lease Accounting: Leveraged lease is a tax-advantage lease arrangement in which a lessor borrows funds to acquire an asset that is then leased to a lessee. The lender holds the title to the asset, while the lessee payments are collected by the lessor and passed to the lender. For financing-type leases, expense recognition would be accelerated. For operating-type leases, expense would be recognized basically on a straight-line basis. 4. FASB Enters New Lease on Healthcare Accounting, March 11, 2018, ( 5. Sean Egan, Accounting Implications of FASB s Redefinition of Leases, AccounTex Report, February 15, etur si aut molupta tibusaperro teseque parum expel ese nimos nos. 5

6 The provider must objectively determine the benefit and cost to the organization, and to disclose key information about leasing transactions on the balance sheet. This may change how lease transactions are reflected in provider s accounting. There is no doubt that a healthcare provider may hold hundreds of contractual agreements. The challenge for a healthcare provider, however, is to first determine if the agreement does in fact contain a lease. In some cases, an agreement may not contain the actual word, lease, however, if the provider has physical control and decision-making authority over the use of an asset, real estate or medical equipment, the agreement will be defined as an agreement with an imbedded lease. Classification determines how entities measure and present lease income and expenses and cash flows. Steps to take may include: Step 1: Develop an inventory of existing contracts. A lease is present in the contract if the contract includes an identified asset. The asset is explicitly or implicitly specified. The supplier has no practical ability to substitute or would not economically benefit from a substitution. Step 2: Discuss with bond counsel the potential impact on bond and other debt agreements. Step 3: Assess impact on balance sheet and income statement Step 4: Confirm the right to control the use of the asset during the term of the lease. 6

7 The lessee has decision-making authority over the use of the asset. The lessee can obtain substantially all economic benefit from the use of the asset. Step 5: Consider impact on debt capacity and answer the question, Can the cash be invested to generate a higher return than the lease expense? Step 6: Evaluate current capital acquisition strategies and potential lease alternatives to renew, terminate, or purchase. Below is a flowchart of the decision-making process for determining if a lease is present in the contract. 6 Scope Leases included in the new standard Lease is of property, plant, and equipment. Does contract contain an identified asset? Asset is explicitly or implicitly specified in the contract. The supplier has no practical ability to substitute the asset and would not benefit economically from substituting the asset. Lease contract must convey the right to control the use of the asset during the term of the lease, that is, how and to what purpose the asset will be used. No Not in scope of ASC 842. Control must convey: Decision-making authority over the use of the asset. The ability to obtain substantially all of the economic benefits from the use of the asset Lease is in scope of ASC 842 Effects to current-state and impacts to future-state, will need to likely facilitate tactical decision-making as the organization positions its equipment and real estate lease portfolio strategically to align with the organization s core service lines in the provider network. 6. Joanne Flood, National Association of Certified Valuators and Analysts, January

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