New Accounting Standards Will Drive Changes in Health Care Leasing Practices

In August 2010, the Financial Accounting Standards Board released proposed new accounting rules for real estate and equipment leases. If these rules become effective, they will dramatically change the way leases are reported in the financial statements of public and private companies and nonprofit organizations. They will have a substantial effect on the structuring and administration of leases, and on the usefulness of certain common lease terms, such as term extension options and formulaic rent escalations.

In the health care industry, where real estate and equipment leases have been used widely to respond to rapid changes in medical specialties, markets, and technologies, the impacts may be significant. Although the proposed accounting standards will not come into effect for two or three years, once effective they will apply to all existing leases. It is not too early to begin planning for these changes.

Current standards

Today generally accepted accounting principles (GAAP) draw a fundamental distinction between an operating lease and a capital lease—a distinction that will be discarded by the new standards. Generally speaking, an operating lease is considered a transitory use, by the lessee, of the lessor’s asset. The lease does not impact the lessee’s financial statements (except that rent liability for the current year is reported on the lessee’s income statement as it accrues). The leased asset remains on the lessor’s balance sheet, subject to depreciation and other changes over time.

By contrast, a capital lease is considered the equivalent of a financed acquisition of the asset by the lessee; the value of the leased real estate or equipment must be carried as an asset on the lessee’s balance sheet, subject to a liability equal to the present value of the lessee’s future rent payment obligations. (The lessor’s financial statements also contain entries reflecting this premise that the lessor has disposed of the asset in a seller-financed transaction.)

Today GAAP distinguishes a capital lease from an operating lease by examining each lease for the presence of certain specific terms. If any of these litmus-test terms are present, the lease must be classified as a capital lease. These include an option for the lessee to acquire the leased asset at the end of the term for no further consideration or at a bargain price; a term in excess of 75 percent of the leased asset’s useful life; or an aggregate rent obligation approaching the fair market value of the asset.

Accounting industry critics say that, under current GAAP, lease transactions are too easily structured to avoid capital lease status, causing extensive use of off-balance-sheet acquisitions of capital assets by means of long-term operating leases—and inadequate financial statement disclosure of what are essentially purchase-money financing transactions.

The Financial Accounting Standards Board apparently agrees. Rather than modify these distinguishing factors, it proposes to scrap the operating lease/capital lease distinction entirely and impose a new regime: “right-to-use” accounting for leased property and equipment. The effect would be to require something similar to capital lease accounting for almost all real estate and equipment leases—but with some significant differences in the details.

The New York Times has estimated that this new standard will require U.S. public companies to add approximately $1.3 trillion in currently nonreported items to their balance sheets, dramatically swelling both the assets and liabilities of the reporting companies. Privately-held companies and nonprofit organizations will also be impacted.

Proposed lessee standards

The new standards will require a real estate or equipment lessee to disclose the lease on its balance sheet from the effective date of the lease.

On the liability side, the lessee will have to report the present value of all future lease payments, calculated using an “expected outcome analysis.” If—as is common today—the lease contains variable terms dependent on future decisions or events—such as a lease term extension option, a rent adjustment clause tied to future CPI, or an expense reimbursement provision that may escalate in amount over time as utility costs rise—the lessee will be required to evaluate possible alternative financial outcomes of such terms, and to weigh the probability of each, in order to calculate the amount of the reportable lease liability.

On the asset side on the balance sheet, the value of the right-of-use asset is initially reported as equal to the present value of future lease obligations, subject to certain one-time adjustments related to the cost of acquiring the lease.

These balance sheet items must be re-evaluated by the lessee, at each reporting period, in light of intervening events affecting the asset or the interest of the lessee in it. The lessee must also report, on its income statement for each reporting period, the implicit interest expense component in the accrued rental payment(s) for the period; and, on its balance sheet, amortization of the value of the right-to-use asset, any impairment losses suffered by the asset, and changes in the lease-related liability attributable to intervening events.

Proposed lessor standards

The proposed standards also present more complexity in accounting for lessors of real estate and equipment. A lessor must make a threshold decision, in the first year of a lease, between two alternative methods of financial reporting for the lease. This choice will turn on whether, during or after the expected term of the new lease, the lessor will have “significant exposure” to the rights and benefits of the leased asset.

A lessor must consider many factors in determining whether it will have such exposure. These factors include the expected term of the lease, whether it may yield significant contingent rentals, whether it calls for the lessor to deliver material services, the remaining useful life of the asset, and the expected value of the asset at the end of the lease term.

Once made, that decision determines which lessor accounting method is applicable to the lease, and the decision is irrevocable. If the lessor determines that it does have “significant exposure,” it must account for the lease using a method similar to current lessor accounting for operating leases. The asset remains on the lessor’s balance sheet, valued at the present value of expected future rent payments plus a residual value.

Like the lessee, the lessor must use a complex “expected outcome analysis” to determine that present value, which calls for an analysis of the most probable lease term and the possible financial consequences of variable economic terms in the lease over time. The lessor’s balance sheet will also carry an offsetting liability for the landlord’s obligation to allow the tenant to use the asset during the lease term.

The lessor’s income statements will reflect the receipt of rental payments, and the performance of lessor obligations, over time. Like the lessee, the lessor must re-evaluate its balance sheet items related to the leased asset at each reporting period to reflect the effects of future tenant decisions and extraneous events on the leased asset or the lessor’s interest in it.

If the lessor concludes that, with the lease in effect, it no longer has “significant exposure” to rights and benefits related to the asset, it must use the different method to account for the lease—derecognition accounting. Similar to current capital lease accounting, this method’s premise is that the lessor has transferred a substantial portion of the value of the asset to the lessee at the commencement of the lease term. Once again, the lessor is required to use an expected outcome analysis to determine the value that the landlord must “derecognize” (i.e., remove from its balance sheet). Corresponding rules for recognition of a limited residual liability, and income reporting, based on this premise are also provided.

Criticisms of the proposed standards

Criticisms of the proposed standards have been in predictable areas. One line of complaint has focused on the difficulties inherent in making the complex forecasting of future events required by the expected outcome analysis. The judgments made and probabilities determined by accountants—usually after the lease has been put into effect—will not be readily predictable to those negotiating the lease transaction. Uncertainty about the effect on financial statements will undermine the acceptability of variable lease terms—such as renewal options—that have served the leasing community well in times of expansion, consolidation or rapid market changes.

Related to this line of criticism are complaints about the cost and time that will be required to complete the more elaborate forecasting of the economic consequences of a lease. Accountants will require more data about the terms of a lease, its performance over time, and events and circumstances potentially affecting the underlying asset. The costs of accounting for leases will unquestionably increase, for both lessor and lessee, if these proposed lease accounting standards are adopted without further modification.

Implications for the health care industry

Leasing has been a frequently-used tool for hospitals and other health care institutions and organizations. For many years, hospitals have developed, or encouraged the development of, on-campus or near-campus medical office buildings occupied by provider groups, in order to promote favorable referral patterns. Real estate leasing can also permit a hospital or research institution to expand its own footprint quickly, in response to changing demographics or land use patterns, without tying up substantial capital in bricks and mortar. Equipment leasing permits medical institutions to use expensive new technologies while minimizing required capital outlays and mitigating obsolescence risks.

The usefulness of leasing as a business strategy will come under closer scrutiny as these new accounting standards take effect. To be sure, many forms of leasing by medical organizations will continue—no other form of financing can offer access to enormous capital assets on such flexible terms—but historical practices and familiar lease terms must be re-examined, and changes will be made.

A primary effect of these new accounting standards will be to bulk up the balance sheets of health care institutions and companies that have used lease transactions to add capital assets to their delivery system or expand their geographic reach. Off-balance-sheet financings will be brought back on balance sheet.

Hospitals and other institutions operating under regulations, or loan or bond covenants, tied to the level of their GAAP-reported liabilities may find themselves closer to the maximum allowable leverage limit—or perhaps over the line. Complex leasing arrangements involving a long-term ground lease, or a lease-sublease pairing, may produce unexpected and undesirable consequences for a hospital’s financial statements. Leases under which the lessor provides both space and substantial ancillary services, in exchange for rent, may have to be deconstructed. Even gross-space leases will be more suspect.

Lease terms that in the past have been useful to entice prospective tenants (such as tenant extension options), or to protect the landlord against future cost escalation, may be much less attractive because of the accounting complexities and uncertainties they will engender. Indeed, the health care institution intent on expansion and confronting the purchase-vs.-lease decision may be much more inclined to purchase to avoid these new burdens of lease accounting.

In any event, hospitals and health care organizations should anticipate the need for more careful administration of their leasing programs, more systematic data collection, and closer coordination with accounting resources in order to minimize the risks of unexpected adverse impacts on the institution’s financial statements.

John Hanley is a partner in the real estate practice and resident in the Seattle office of Davis Wright Tremaine LLP. Davis Wright has a nationally prominent health care law practice, providing services to hospitals, medical clinics, research institutions, and other nonprofit and for-profit companies in a wide range of legal specialties, including regulatory affairs, employment, litigation, tax, business transactions, and real estate.

For more information about our health care practice, please contact Bob Homchick at roberthomick@dwt.com (206.757.8063). For more information about our real estate practice, please contact John Hanley at johnhanley@dwt.com (206.757.8262).