By A.J. Hurst, CPA
Hospitals, clinics, and long-term care facilities enter into lease agreements for a variety of assets, ranging from clinical office space to medical equipment (MRI machines, C-arms, etc.) and other standard office equipment (copiers, etc.). Given the significance of these leasing activities, healthcare providers should be aware of the potential significant impacts of the adoption of Accounting Standards Codification (ASC) 842, the new lease accounting standard. The new standard is applicable to all corporate entities reporting financial statements under U.S. GAAP.
The adoption of ASC 842 will effectively move the Company’s operating lease obligation disclosures out of the footnotes to the face of the financial statements. Generally speaking, ASC 842 will require healthcare entities to record the impact of operating leases on the balance sheet as assets (referred to as right-of-use assets under ASC 842) and liabilities (lease liabilities). Operating lease expense will still be recognized on a straight-line basis in the current year income statement. While this move to the financial statement does not reflect any change in your business operations, it is possible it will impact your bank covenants.
ASC 842 has been effective for public companies for multiple years and will be effective for private companies and certain not-for-profit entities beginning with annual periods beginning after December 15, 2021 (the fiscal year 2022 for calendar-year entities).
In addition to the most significant impact of adopting ASC 842 described above, healthcare entities should also be aware of some of the less significant areas of ASC 842: (1) embedded leases; (2) identifying different lease and non-lease components within agreements; and (3) the short-term lease exemption.
Healthcare entities often enter into agreements for services which may include an equipment component or other tangible asset that is used by a company as part of receiving the services from the vendor. Under ASC 842, companies must analyze these agreements, including across all company departments, to determine if the company potentially has an embedded lease arrangement related to the included equipment. The key considerations for companies to determine if service agreements include embedded leases are as follows: (1) the arrangement includes an identifiable asset; (2) the arrangement includes the right to control the assets; and (3) the arrangement spans a period of time. This could potentially result in the company recording right-of-use assets and lease liabilities under ASC 842.
Identifying lease and non-lease components
Many contracts include lease components and non-lease components. Non-lease components could include maintenance components, insurance, taxes, etc. Under ASC 842, entities should review cash payments under contracts determined to be leases and allocate the payments between lease and non-lease components. ASC 842 includes a practical expedient to combine lease and non-lease components and account for the related payments as a single lease item. This would require entities to make a policy election to not separate the components. Allocating amounts between lease and non-lease components could potentially impact the amount of right-of-use assets and lease liabilities recorded by an entity on the balance sheet.
Short-term lease exemption
ASC 842 includes an exemption for companies to make a policy election to not record right-of-use assets and lease liabilities for leases with terms of 12 months or less. Instead, companies will continue to recognize payments under short-term leases as lease expenses on a straight-line basis over the lease term.
Any time there is a significant new accounting standard, certain implementation issues will be faced by many entities. As part of the adoption of ASC 842, healthcare entities could potentially face implementation issues, which may include:
- being able to identify the population of agreements potentially subject to ASC 842
- effectively monitoring and updating lease agreement populations,
- updates to internal controls needed as part of the adoption of ASC 842,
- potentially implementing specific lease accounting software, and
- the impact of the adoption of ASC 842 on debt covenant calculations.
Finance and accounting departments within large healthcare organizations often have a hard time tracking all leases, monitoring updates to leases, and properly accounting for leases because leases are negotiated and maintained within operations or facilities departments. Understanding the population of leases utilized by companies will be a key part of effectively adopting ASC 842.
Similarly, companies will need to evaluate internal controls related to leases and lease accounting for any changes required as part of the adoption of ASC 842. Healthcare entities may find it useful to include the implementation of a specific lease accounting software as part of the full internal control system to replace more manual tools currently used, such as basic spreadsheets. Several new products are available that have been designed to specifically apply to accounting for leases under ASC 842.
Companies should communicate with their lenders, private equity owners, and other financial statement users to effectively communicate the potential impact of the adoption of ASC 842 on their financial statements and financial covenant calculations. Most financial statement user groups have also been briefed on the impact of ASC 842 adoption for all entities, but closely reviewing compliance requirements and calculations will help alleviate any potential issues explaining the impact of ASC 842 on covenant calculations.
Lastly, companies should also understand the potential footnote disclosure impacts of the adoption of ASC 842. For healthcare entities, this may include notes related to the actual impact of the adoption on an entity’s financial statements, the election of any practical expedients, and details related to future undiscounted lease payments reconciled to lease obligations recorded on the balance sheet.
With the pending effective date of ASC 842, the Frazier & Deeter Healthcare Group is available to assist with any questions or implementation issues your company may have as part of your transition to the new lease accounting standard. Our Healthcare Group works closely with our internal lease accounting experts to assist companies with navigating the new lease accounting landscape.
About the Author
A.J. Hurst is the Vice-Chair of Frazier & Deeter’s National Healthcare Industry Group. He serves as a Senior Manager for the firm’s clients and as an internal technical accounting and audit resource within Frazier & Deeter’s audit practice. He is also the former Chair of the Training & Development Subcommittee of the firm’s Technology Practice and his articles have appeared in industry publications such as the Journal of Accountancy.