Impact of new Lease Standards on Tech and Life Sciences Companies

This is a Guest blog post from Ling Zhang., CPA.

 

When the Financial Accounting Standards Board (FASB) met on May 20, 2020 to address the impacts of the COVID-19 pandemic, they voted on a one-year effective date deferral of Accounting Standards Codification (ASC) Topic 842, Leases, which will result in a modified effective date for private companies and certain private not-for-profit entities for fiscal years beginning after Dec. 15, 2021, and interim periods with fiscal years beginning after Dec. 15, 2022, once the final standard is issued (expected June 2020). Private companies in technology and life sciences, particularly with significant operating lease activity under current lease accounting guidance, can take advantage of the delayed ASC 842 effective date to prepare for implementation.  

FASB originally issued Accounting Standards Update (ASU) 2016-02 in February 2016. Accounting Standards Codification (ASC) Topic 842, Leases, along with several subsequently issued related ASUs, which amended the accounting guidance for leases.

GENERAL ASC 842 REQUIREMENTS

Under ASC 842, a company is required to recognize leases with terms greater than 12 months on its balance sheet. Specifically, lessees are required to recognize the following at lease commencement:

ASC 842 represents a change for operating leases that were historically considered “off balance sheet” obligations. FASB believes a balance sheet presentation of leases will provide a clearer view of a company’s future commitments with operating leases recognized on the balance sheet.

Under ASC 842, leases recorded on the balance sheet will be classified as either finance leases or operating leases, which will determine the presentation of the related expense in the income statement. Finance lease arrangements will result in depreciation and interest expense recorded each reporting period similar in manner to existing capital leases under legacy guidance. Operating lease ROU assets and liabilities will be amortized and accreted, respectively, to develop a straight-line rent expense presented as lease expense in the income statement.

SPECIFIC CONSIDERATIONS FOR TECHNOLOGY AND LIFE SCIENCES COMPANIES

The delayed ASC 842 effective date provides additional time for technology and life sciences companies to prepare for implementation. Specific considerations prior to implementation include:

1. Impact to Balance Sheet and Financial Ratios

Technology and life sciences companies should expect increases in balance sheet amounts (e.g., long-term assets and both current and long-term liabilities) for operating leases. Companies with significant existing operating leases may be surprised by the impact on reported balance sheet amounts. These financial statement changes may impact certain financial ratios, including current ratio, leverage ratio and debt service coverage ratios.

Example: How ASC 842 Can Affect Key Metrics

As many technology and life science companies use cash flow-based lending, the example below provides the potential effects on the balance sheet and the associated debt service coverage ratio. Some do not consider operating lease liabilities as ‘debt’ for purposes of calculating debt-based ratios and you can expect that there may be diversity in practice. Technology and life science companies should confirm with their lenders in advance their view of the treatment of ASC 842 operating lease liabilities with regard to covenant calculations.  Understanding the impact on key metrics early is advised. The following is an example showing the impact on certain ratios when operating lease liabilities are considered debt.

Balance Sheet Impact

Notice how the reporting of ROU assets and lease liabilities increases the total amount of assets and liabilities on the balance sheet after adopting the new standard.¹

Balance Sheet
	Prior to adopting ASC 842	After adopting ASC 842
Cash	$                    500,000	$                  500,000
Accounts receivable	750,000	750,000
Inventory	2,000,000	2,000,000
Total current assets	3,250,000	3,250,000
PPE	500,000	500,000
Capitalized software	1,500,000	1,500,000
Operating lease ROU asset	–	900,000
Total non-current assets	2,000,000	2,900,000
Total assets	5,250,000	6,150,000
Deferred revenue	$                 2,100,000	$               2,100,000
Accounts payable and accruals	550,000	550,000
Long-term debt, current	100,000	100,000
Operating lease liability, current	–	250,000
Total current liabilities	2,750,000	3,000,000
Long-term debt, net of current portion	400,000	400,000
Operating lease liability, net of current portion	–	650,000
Total non-current liabilities	400,000	1,050,000
Total liabilities	3,150,000	4,050,000
Equity	2,100,000	2,100,000
Total liabilities and equity	$                 5,250,000	$               6,150,000

1) In this example, it is assumed that the lease liability in an operating lease. However, if the lease liability was classified as a finance lease, the ROU asset could be included within PPE.

Debt Service Coverage Ratio Impact

Debt service ratio coverage is a common financial covenant found in debt agreements. As illustrated below, the ratio may significantly change with the adoption of the Standard.

Debt Service Coverage Ratio
	Prior to adopting ASC 842	After adopting ASC 842
Net income	500,000	500,000
Depreciation expense	50,000	50,000
Interest expense	20,000	20,000
	570,000	570,000
Interest expense	20,000	20,000
Current portion debt and capitalized leases	100,000	350,000
	120,000	370,000
Debt service coverage ratio	4.75	1.54

 

Many technology and life sciences companies may find that certain metrics and loan covenants are impacted due to the changes in the balance sheet as a result of adoption. Companies should give priority to their financial statement and disclosure changes for the purpose of maintaining compliance with their loan covenants. As previously discussed, companies should also engage in early communication with their lenders regarding the potential impact on financial covenants and whether the lenders will take these changes into consideration when analyzing the company’s performance.

2. Lease Population Completeness Considerations

During the ASC 842 transition, all leases should be identified. While many leases may seem straightforward, such as leases for real estate or equipment, others may be embedded within other service contracts. For example, a router that is utilized as part of an internet service arrangement may be considered a leased asset. By electing the package of three transition practical expedients, companies are allowed to not reassess the following:

• whether any expired or existing contracts are or contain leases;
• lease classification for any expired or existing leases; and
• indirect direct costs for any existing leases.

 

Embedded leases are commonly found in the following arrangements:

A lease exists if a contract conveys to a company the right to obtain substantially all of the economic benefits from use of the identified asset and the company directs the use of the identified asset. An identified asset must be physically distinct and specified in the contract. The existence of substitution rights may indicate a specific asset has not been identified. Under Topic 842, substantive substitution rights exist when a supplier has the practical ability to substitute alternative assets throughout the period of use, and the supplier would benefit economically from the exercise of its right to substitute the asset. When evaluating the existence of a lease, companies also need to assess if the use of the identified asset is significant. If another party’s use of the identified asset is more than insignificant, the contract does not convey control of the identified asset, therefore, the contract does not contain a lease.

 

The following are some examples where judgement and further analysis may be required to determine the presence of a lease component.

 

REVENUE CONTRACT WITH CUSTOMER – SUBSTITUTION RIGHT A: SaaS contract with hosting arrangement – identified asset without substantive substitution rights Facts: A software company enters into contracts with its customers to host software on the software company’s servers, each of which is designated to a specific customer. The contracts do not allow the software company to substitute the server for another one without consent of its customers.   Analysis: An embedded lease may exist (even without an explicit lease agreement) considering that the server is dedicated to a specific customer, and the software company does not have “substantive substitution” rights for the server.   B:  SaaS contract with use of equipment – identified asset with substantive substitution rights Facts: A company enters into a contract with a customer that includes SaaS services and the use of a designated computer medical cart through the term of the SaaS services. The company has the option to swap the medical cart with another one at any time.   Analysis: The Company can swap the medical cart with another one at any time during the term of the contract. Therefore, the “substantive substitution” rights criteria has been met, and the use of the computer medial cart is not considered a lease.

 

MEDICAL SUPPLIES PURCHASE CONTRACT – IDENTIFIED ASSET WITHOUT SUBSTANTIVE SUBSTITUTION RIGHTS Facts: A bio-tech company enters into a medical supplies contract, which requires the purchase of consumables and test kits for research and development purposes exclusively from this supplier for the term of five years. As part of the arrangement, the supplier also provides the equipment for testing at no charge. The equipment is installed and customized for the bio-tech company, and the contract does not allow the supplier to substitute another equipment without the approval of the bio-tech company.   Analysis: A lease may exist since the equipment is specified in the contract and designated to the bio-tech company; At the inception of the contract, the supplier does not have substantive substitution rights to the equipment and it is not feasible that the equipment can be easily substituted by the supplier.

 

INFORMATION TECHNOLOGY (IT) SERVICE CONTRACT – IDENTIFIED ASSET WITHOUT SUBSTANTIVE SUBSTITUTION RIGHTS Facts: A technology company enters into a network services and security agreement with an electronic data storage provider. The services are provided through a centralized data center and use a specified server (Server No. 9). The supplier maintains many identical servers in a single accessible location and determines, at inception of the contract, that it is permitted to and can easily substitute another server without the customer’s consent throughout the period of use.   Analysis: Based on the facts above, the vendor can interchange the underlying asset without the customer’s consent. As the asset is interchangeable in nature and service and is not dependent upon the specific asset, there is no lease based upon the “substantive substitution” rights criteria.

 

ADVERTISING CONTRACT – SIGNIFICANCE OF USE Facts: A company enters into a marketing services agreement which encompasses a variety of marketing and advertising vehicles, one of which includes electronic billboards.   Analysis: Although this contract could be written as a marketing services agreement, the right to use one or more billboards may result in a lease if the billboard is specifically identifiable and dedicated to the company, and the company obtains significant use of the billboards throughout the term of the contract. Understanding if other parties have the right to advertise on the billboards and the significance of those other arrangements will be important to determining if a lease exists.

 

Considerable judgement is involved for each example when reviewing a contract for embedded leases. A slight alteration in facts and circumstances may result in a different conclusion. Keep in mind that if there is a specifically identified asset dedicated to a party, it is likely to contain a lease. Further, predominance and significance of the activity will impact lease related decisions and conclusions.

 

3. Negotiation of Future Arrangements

The impact of ASC 842 may be an important factor in evaluating whether to structure the acquisition of assets as lease arrangements or purchase arrangements going forward. Further, Topic 842 may have implications on other accounting standards such as revenue recognition. The consideration of future arrangements will be particularly important for companies with significant lease activities as many such lease arrangements may move on to the balance sheet under the ASC 842. Technology and life sciences companies should identify and perform an inventory of all existing leases, including embedded leases, in conjunction with forecasting needs for future assets. The company can then evaluate and plan for these future needs with a clear understanding of the trade-offs between lease and purchase arrangements.

 

4. Tax Impact

ASC 842 will have a noticeable impact on financial reporting for lessees, but the effect on taxes may not be obvious. The new lease standard does not change lease accounting for federal income tax purposes. Therefore, without a corresponding change in tax basis, deferred tax accounting may be impacted. Implementation of ASC 842 could result in new deferred tax assets, liabilities or additional book to tax differences in a company’s income tax provision. Under ASC 842, lease assets are subject to impairment, which is often reversed for tax purposes. Technology and life sciences companies should understand and plan for the potential tax impact.

 

5. Assurance Perspective

Technology and life sciences companies audited by an independent public accounting firm should maintain relevant documentation of the ASC 842 implementation process, as the independent auditor may require the documentation in order to complete the audit. Such documentation should include evaluation of lease classification as finance or operating, selection and application of the transition method, discussion of any practical expedients applied, basis for significant assumptions such as discount rate and the company’s lease identification completeness procedures, including evaluation of embedded leases.

 

6. Future Operations, Processes and Related Controls

To comply with ASC 842, companies will likely need to implement changes to their current control environments and business processes. Companies should establish policies and procedures to address ongoing considerations such as initial assessments of new contracts, appropriate interest rates and lease modifications, as well as develop methods to appropriately capture financial disclosure information. Significant judgement will be required to assess lease terms through an ASC 842 lens, specifically related to lease term, allocation of lease payments to lease and non-lease components, and remeasurement events.

 

CONCLUSION

By delaying the effective date for non-public business entities, FASB has created an opportunity for technology and life sciences companies to fully consider the impact of ASC 842 and prepare for the upcoming transition.

 

As a Senior Manager in the DHG Technology practice, Ling Zhang, CPA, works closely with client management and C-suite executives to provide audit, financial accounting advisory, and risk advisory services to multi-national publicly-traded corporations and private companies with revenues ranging from $10 million to $50 billion. She advises clients on SEC filings, complex debt and equity transactions, merger and acquisition, new accounting guidance implementation, internal control system design and implementation, and financial statements reporting and disclosures. She can be reached at ling.zhang@dhg.com.