CHANGES IN LEASE ACCOUNTING AND WHAT PROVIDERS NEED TO KNOW - Navigant
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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, private-
sector, 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-for-
profit 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.”
http://www.fasb.org/jsp/FASB/Page/LandingPage&cid=1175805317407
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
Growth in total Healthcare
Real Estate Assets 2013-2016
Top 50 Owners of Medical Real Estate
$400
$380
$350.5
$360
$331.5
$340
$320 $297.5
Billions
$300
$267.5
$280
$260
$240
$220
$200
2013 2014 2015 2016
Source: Revista and Revistamed.com
2. John B. Mugford, “Top 50 Owners of Medical Real Estate,” Healthcare Real Estate Insights, September 25, 2017.
http://wolfmediausa.com/2017/09/25/cover-story-top-50-owners-of-medical-real-estate/.
2
Healthcare providers have a strong preference to own facilities provided to patients if the patients were referred by physicians
that house a core mix of services for their patients. In the who had a financial relationship with the provider, thus
Houston market, for instance, eliminating conflicts of interest and possibly reducing quality of
patient care outcomes.
“Houston Methodist continues to bring convenience and care
to patients in locations around the greater Houston market,” To mitigate hospital risks of owning real estate, providers began
notes Sid Sanders, Houston Methodist, SeniorVice President, to lease space from third-party entities, and remained cautious:
Construction, Facilities Design and Real Estate, “We continue
•• Ensuring lease agreements were made specific to its use.
to move forward with our plan to build a facility platform
•• Confirming lease agreements were properly authorized.
designed to best serve our patients. As part of that plan we
opened a 193 bed multi-specialty acute care hospital last June •• Making sure leases were up-to-date with no lapse in time.
in the Woodlands and will open a 366 bed replacement and •• Ensuring rents negotiated and paid at fair market value.
expansion tower in the Texas Medical Center this Summer. We
•• Reinforcing and monitoring to compliance standards of use.
are also building a distributed network of primary care and
•• Monetizing physician-owned properties when acquiring
specialty care clinics as well as expanding and renovating our
physician groups.
existing acute care platforms as warranted to meet the needs
of our patient population. While large capital moves such as
ACCOUNTING METHODS FOR LEASES
these are infrequent, they are still an important strategic part
of our capital plan.” Operating Lease
Owning healthcare real estate requires an intentional strategy A majority of leases are operating leases. An operating lease
and recognition of the accounting treatment for capital and is treated like rent — payments are considered operational
operating leases. The differences can have significant impact on expenses and the asset being leased stays off the balance
taxes owed by the provider. It is important to understand the sheet, and thus the corresponding debt liability does not have
definition of current accounting rules in order to implement the to be calculated or included. Operating leases provide much-
ensuing changes to accounting methods. needed flexibility as updates and replacement of equipment are
expected, and typically come with a protection of obsolescence
An alternative to a provider owning real estate assets, is a in the lease agreement. The highest benefit is that lease
strategy to preserve capital and long-term flexibility. The payments are operational expenses and are fully tax deductible.
objective “Right Care, Right Place, Right Time, and Right Cost,” This provides an improved return on asset without capital
takes capital and may require leveraging third-party capital to budget restraints.
attain speed to market, reduce risk of a real estate asset, and
create a predictive cost of rent. Leasing versus owning will Under current FASB rules, long-term leases for real estate assets
increase project/strategic investments, and improve return on are classified as operating leases. Operating leases typically
investment and internal rate of returns. Benefits to the hospital don’t impact the balance sheet of the lessee. Healthcare
providers have been able to classify long-term leases for
or healthcare system are leasehold rights to the facility for 10
healthcare facilities as operating leases. Existing rules have
to 20 years. Branding is transparent and the provider continues
allowed providers to monetize noncore assets like medical office
to preserve capital for the use of electronic health records,
buildings through sale-leaseback arrangements with little impact
physician recruitment, the latest in technology, and key initiatives
on their balance sheet.
to support patient care.
Partly due to the Patient Protection and Affordable Care Act Capital Lease
of 2010 and the Health Care Education and Reconciliation
In contrast, a capital lease is more like a loan or debt — the
Act, released the same year, some previous leasing practices
asset is treated as being owned by the lessee so it stays
changed. Prior to 2010 it was not uncommon for some of the
on the balance sheet. Capital leases recognize certain
leased facilities to be owned by physician groups that referred
expenses sooner than operating leases: the lessee is allowed
patients to the leaseholder. The mandates reflected in the Stark
to claim depreciation each year on the asset. In addition, the
Law, made it illegal for healthcare providers to submit claims
interest expense component of the lease payment can also be
for federal Medicare or Medicaid reimbursement for services
deducted as an operational expense.
3
EARLY ADOPTERS
It has been two years since the FASB issued its final standard •• Impact on income statement?
(ASC Topic 842), which delineates the changes that will be •• Profit and loss results?
made to lease accounting. The new FASB Lease Accounting
Changes, FAS 13 and IAS 17, updated in January 2018, will Answers to these questions will no doubt create a cumbersome
take effect in January 2019 for public entities, and in January network of required reviews and take time. The accounting
2020 for all other entities.3 Proposed changes would virtually change will make lease management and accounting more
eliminate operating lease accounting treatment for providers complex. The new accounting model will require sophisticated
that lease real estate, and require assets and liabilities to be financial calculations and will mandate more monitoring and
reported similarly to capital or finance leases. But there are some tracking of lease details throughout the life of a lease.
differences in how these assets and liabilities are measured.
WHERE DOES A PROVIDER BEGIN?
To meet the multifaceted challenges of disruption to financial
accounting rules, the healthcare industry must re-examine their It is no wonder that some providers have become early adopters,
current lease practices and answer some tough questions: initiating a thorough filtering of their equipment and real estate
leases well before the deadlines. With the exception of short-
•• Own or lease? term leases (term of 12 months or less), real estate leases will be
•• How long to lease? treated as capital/finance leases. It is imperative that all other
leases should be reviewed and tagged for either a lease renewal,
•• Determination of asset or liability to the balance sheet.
lease termination, or right to purchase.
−− Operating Lease?
−− Capital lease/Finance lease?
When evaluating lease vs. own, the impact It may be that a lessor may
on key financial ratios and credit rating have already been approached
should be considered = profitability/ by the lessee to reduce their 11-Month Lease
operating margin, debt position (cushion lease term to less than 12
ratio, long-term debt/cap) and liquidity months. Reporting leases with
(days cash on hand), and cash to long-term these terms are given an
debt). Consider impact on debt capacity exemption as a debt liability.
and answer the question, “Can the cash
be invested to generate a higher return
than the lease expense?”
The objective of financial reporting is to increase transparency The good news is that there are many benefits to leasing,
and comparability among organizations by recognizing despite the lease accounting changes:
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.
Maintain Cash Flow Preserve Capital Obtain Flexible
Financing
3. FASB. “Accounting Standards Update.”http://www.fasb.org/jsp/FASB/Page/SectionPage&cid=1218220137102.
4
To fully leverage lease accounting changes, the healthcare For an arrangement to be a lease, or to contain an embedded
provider — the lessee — must focus on responses that result lease, it should convey to the provider the right to control the
in the maximization of the provider’s bottom line. The lessor, use of a real estate asset and equipment for a period of time in
however, will also be affected. exchange for approved lease consideration.
Lessor Impacts The implementation of FASB (ASC Topic 842) will require real
estate lessors to use operating lease accounting methods and
•• Lessor accounting remains essentially unchanged; according
recognize depreciation of an operating lease on a straight-line
to the FASB, a majority of operating leases should remain
basis, or accounts receivable residual approach to front-load
classified as operating leases, and lessors should continue
lease expenses, all determined under current GAAP.4
to recognize lease income for those leases on a straight-line
basis over the term of the lease.
UNDERSTANDING CURRENT STATE AND
•• For an arrangement to be a lease, or to contain an embedded
FUTURE STATE
lease, it must convey to the provider ‘the right to control
the use of the asset for a period of time,’ in exchange for With respect to expense recognition, the FASB classifies leases
approved lease consideration. 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 FUTURE STATE
Risk-Reward Approach: Right-of-Use Approach:
Distinguishes between an operating lease and a Lessee to account for each equipment lease contract’s
capital lease. rights and obligations as assets and liabilities.
Present Value: Present Value:
Rent recorded as an expense if provider did not own the Providers/lessees to record the present value of the lease
asset (i.e., real estate). rent as an asset and liability.
Equipment Leases: Equipment Leases:
Expenses related to equipment leases would be Depending upon how much of the leased item is
recognized as interest. consumed during the term of the lease, expenses related
to equipment leases would be considered financing
contracts.
Short-Term Leases: Long-Term Leases:
No change. Long-term operating leases will appear on the balance
sheet as nondebt liabilities.
Leverage Lease Accounting: For financing-type leases, expense recognition would
be accelerated.
Leveraged lease is a tax-advantage lease arrangement
in which a lessor borrows funds to acquire an asset that For operating-type leases, expense would be recognized
is then leased to a lessee. The lender holds the title to basically on a straight-line basis.
the asset, while the lessee payments are collected by the
lessor and passed to the lender.
4. FASB Enters New “Lease” on Healthcare Accounting, March 11, 2018, (http://www.pyapc.com/fasb-enters-new-lease-healthcare-accounting)
5. Sean Egan, “Accounting Implications of FASB’s Redefinition of Leases,” AccounTex Report, February 15, 2018.
https://www.accountexnetwork.com/blog/2018/02/new-lease-accounting-standard-recordkeeping-will-evolve/jkljdlaksjdlajsdlksajldkjlaskjdlaksjdlkasUt etur si aut molupta
tibusaperro teseque parum expel ese nimos nos.
5
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•• The lessee has decision-making authority over the use of Step 6: Evaluate current capital acquisition strategies and
the asset. potential lease alternatives to renew, terminate, or purchase.
•• The lessee can obtain substantially all economic benefit from
the use of the asset. Below is a flowchart of the decision-making process for
determining if a lease is present in the contract.6
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?”
Scope — Leases included in the new standard
Lease is of property, plant, and equipment.
Yes
Does contract contain an identified asset?
Yes
No
Asset is explicitly or implicitly specified Not in scope of
in the contract. ASC 842.
Yes
The supplier has no practical ability to
substitute the asset and would not benefit
Control must convey:
economically from substituting the asset.
• Decision-making authority
Yes over the use of the asset.
• The ability to obtain
Lease contract must convey the right to
substantially all of the
control the use of the asset during the term
economic benefits from the
of the lease, that is, how and to what
use of the asset
purpose the asset will be used.
Yes
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 2018. http://quickreadbuzz.com/2018/01/24/lease-accounting-2018-update/
7CONTACTS
SHARON CARTER
Director
+1.312.583.4176
sharon.carter@navigant.com
navigant.com
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