Make sure your organization is prepared for the possible upcoming accounting changes associated with leases.
As hospital managers are faced with important decisions regarding technology and equipment upgrades, odds are they are using leases as a financing solution. Hospitals lease almost everything—from large-scale items like diagnostic imaging machines and real estate to the utensils in the dining facility. Is your hospital ready for possible accounting changes on the horizon that will impact how you report leases?
In an effort to promote more transparency for all financial obligations, both the Financial Accounting Standards Board (FASB) and its international counterpart, the International Accounting Standards Board (IASB), are currently working to develop new lease accounting standards. Exposure drafts from August 2011 laid out the proposed changes, which, if implemented in 2013 to 2014 as scheduled, could have dramatic impact on the balance sheets and income statements of many hospitals.
At present, the accounting treatment for leases of US companies is determined in accordance with FASB 13, which details a series of tests that must be conducted in order to determine if a lease is characterized as either a capital lease or an operating lease. These tests include, among other matters, the lease term relative to the asset’s useful life, any transfer of ownership at lease expiration, as well as a financial calculation where the present value of the rental stream cannot exceed 90% of the asset’s value when discounted at the lessee’s incremental borrowing rate. Most hospital operators and hospital CFOs are accustomed to these requirements and incorporate them into their ordinary budget/procurement process.
When a lease is classified as an operating lease, the lease payments flow through the income statement and the underlying asset remains “off balance sheet.” This is often desirable for a number of reasons, such as bond indenture covenant compliance, bank loan covenant compliance, and internal debt constraints. Many institutions require operating lease treatment for internal budgetary compliance. When these obligations are characterized instead as capital leases, the asset financed by the lease is recorded on the balance sheet and the lease is characterized as a liability. Corresponding depreciation and interest expenses impact the income statement.
Under the proposed accounting changes, virtually all leases would be characterized as capital leases with a few additional twists that will certainly impact many hospital balance sheets. There will be requirements for “re-measurement” under the new guidelines, which means that potential changes, such as contingent rent, will be included in the asset cost. However, the most impactful item under the proposed standard will be a requirement that all preexisting operating leases be brought onto the books at one time rather than gradually so that there will be an unusually high concentration of interest expense in the transition year.
Impact on Hospitals
For hospitals, the impact is all about the timing. In theory, the total cash outlay of either type of lease should be the same. The difference will be in the treatment of those expense items highlighted above. Because the lease payment will now be broken down into depreciation and interest expense, there will be a larger amount expensed in the early years of a lease. This will immediately change vital calculations for many bond indenture covenants, particularly earnings before interest, taxes, depreciation, and amortization (or EBITDA) as contrasted to simply reporting a rental expense under an operating lease. Pressure will be brought to bear on vital debt service coverage ratios. Interestingly, some hospitals and hospital systems are already requiring that lease quotations include a capital lease solution in anticipation of these changes.
The Future of Leases
Although these anticipated changes would have a negative impact on the way many hospitals account for some leases, leasing will remain a popular tool in equipment procurement. The advantages of utilizing a lease are still compelling for the following reasons:
- Benefits to budgeting: many financial professionals insist on matching a financing instrument with the useful life of the underlying asset
- 100% financing: leasing typically doesn’t require any down payment or out-of-pocket expenses
- Preservation of other credit vehicles: leasing is still a perfect complement to traditional bank financing, such as lines of credit or term loans
- Convenience: many equipment vendors provide their own finance options or recommend preferred companies for expedient lease finance solutions at the point of sale
- Fair market value leases: equipment leasing companies will still be able to structure leases with more favorable cash applications, no matter the accounting changes
Demand for capital equipment is expected to increase in the coming decade as older technology begins to exhaust its anticipated life cycle. In addition, under new federal health care guidelines, there should be an additional 30 million Americans eligible for health insurance coverage. This potential increase in overall patient census means hospitals will continue to need equipment and technology, and will likely turn to financing to acquire the assets necessary to provide quality care. Leases, no matter how they are accounted for, will continue to be the fuel of the equipment procurement engine.
Moreover, innovative leasing solutions will become more prevalent as hospitals seek alternative methods to acquire technology necessary to offer the best possible clinical solutions. Finance programs with fee-per-study arrangements and bundled lease payments that include services and disposables might become more popular as hospitals seek to match the costs of patient care outlays to the corresponding revenue source. Many equipment manufacturers are working with their in-house and preferred leasing providers to provide such solutions.
How can you be certain your hospital is prepared for these changes? The proposed changes are not yet final and an additional exposure draft is being circulated at this time. However, hospitals using leasing as a financing solution are encouraged to start their planning for the inevitable changes now.
What steps should your organization take to be prepared?
- Start utilizing a simple lease versus buy analysis as it is better to determine now if treating the lease as a cash purchase makes the project any less viable.
- Consider more traditional financing alternatives such as equipment finance agreements, installment loans, or secured term loans that might obtain the desired outcome without the extra work of accounting for a “lease.” Most leasing providers can deliver these types of financing arrangements.
- Be certain that appropriate data collection on leases and their underlying assets is under way. Begin the information capture process now so as to avoid logjams closer to the time of transition. Determine what level of data collection and reporting will be required to comply with the new standards.
- Review all current debt instruments, such as bonds and term loans, to determine how the proposed changes might impact existing financial covenants.
- Engage bond counsel, underwriters, and lenders now to obtain their advice on what the impact might be on existing obligations and determine if modifications might be warranted.
It is recommended that your hospital always confer with its certified legal, tax, and accounting professionals to conclude what is best for your organization. It is a given that hospitals need to obtain the best equipment and facilities possible for their patients and employ the most appropriate contemporary financial instruments in order to accomplish this. To ensure that hospitals maintain the highest level of patient care, the best advice is to prepare early for these changes by exploring and adopting financing solutions that can help achieve that goal.
Michael J. Sweeney is general manager of healthcare finance at EverBank Commercial Finance Inc in Parsippany, NJ. www.everbankcommercialfinance.com