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ASC 842 introduces critical lease decisions for healthcare entities

Oct 23, 2020

When ASC 842 goes into effect, it will change how lease agreements are accounted for on financial statements for fiscal years beginning after December 15, 2019. While most healthcare organizations are focused on obvious changes, such as recording all leases over 12 months as a right-of-use (ROU) asset and lease liability, the new standard will also impact components of external and operational reporting.

For example, organizations need to review their service agreements for embedded leases. The change in financial reporting may also impact ratios that are used in debt covenants for current or prospective lending agreements.

Prepare for every impact on financial reporting, not just the obvious impacts. Start by reviewing these key considerations and discussion points with your accounting team.

Embedded leases

Healthcare companies often use equipment from third parties in exchange for the purchase of inputs and services. Since these contracts don’t classify payments as “leases” or “rent,” they are often treated as service agreements, with payments being expensed in the period in which they occurred.

Under legacy generally accepted accounting principles (GAAP), these agreements may be considered leases, despite explicit language otherwise in the contract. That means treating an operating lease as a service agreement was not financial misstatement under ASC 840. However, under ASC 842, ROU assets and lease liabilities with terms greater than 12 months must be recorded for all operating and finance leases.

If three elements are present — an identifiable asset, the right to control the asset, and a contract that spans a period of time — then an arrangement may contain an embedded lease under ASC 842. The new standard covers any identifiable asset (it need not be explicit).

Work with other departments to assess operations for equipment, buildings, software and other assets that are used in exchange for some sort of consideration (including noncash, other than the guarantee of the lessor’s debt). Failure to identify embedded leases could lead to erroneous financial reporting.  

The impact on debt covenants

When adopting ASC 842, an entity’s liabilities will inevitably increase along with their total assets. Changes in assets and liabilities will impact financial ratios, which may influence compliance with debt covenants.

Take the following actions to avoid debt covenant violations:

  • Calculate the impact of ASC 842 on current debt covenants: The new standard may not impact current covenants since lease liabilities do not constitute debt and would not be factored into ratios such as debt to equity. Tally up the impact to be sure and alleviate concerns.
  • Review current covenants: Some debt covenants contain clauses that exclude changes in financial ratios that arise solely from changes in financial reporting in accordance with GAAP. Such clauses are referred to as “frozen GAAP” verbiage and would excuse organizations from updating their covenant calculations to incorporate ASC 842.
  • Communicate with lenders: Proactively communicate changes in the financials and applicable ratios as a result of ASC 842. Many financial institutions are aware of GAAP accounting changes and are open to discussing whether existing borrowing arrangements could be amended or restructured. The “frozen GAAP” clause may prevent the new standard from impacting debt covenants now, but the requirement to calculate ratios under legacy GAAP could become complicated in future years.
  • Review future borrowing agreements: Before entering into new debt agreements, ensure contract language excludes the impact of lease liabilities and other prospective accounting changes when complying with borrowing requirements.

How Wipfli can help

Hospitals, clinics and long-term care facilities enter into lease agreements for a variety of assets, ranging from high-cost medical equipment to less expensive business supplies. That won’t — and shouldn’t — change when the new standard goes into effect.

To prepare for the new standard, educate lenders and colleagues on changes. Then adapt processes and financial systems as needed. Reach out to Wipfli for help making a smooth transition. We have resources, like the ASC 842 top 10 FAQs, and we offer on-site consulting and support. Contact us today to learn more.

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Wipfli Editorial Team