With respect to the proposed changes to lease accounting, the Banking Industry is somewhat unique in that these lease accounting changes will impact banks in customer relationships with the bank as a lender and will also impact the industry operationally with the bank as a lessee.
The Bank as a Lender
The impact of the issued changes on borrowers’ financial statements could be significant, depending upon the extent of leasing being done and the type of assets being leased by the borrower. Liabilities will certainly increase, expense recognition will probably be accelerated, and expense classifications will probably change, along with cash flow classifications. Bank lending departments may have already tried to adjust for existing operating lease “liabilities” in their internal evaluation of borrowers’ financial statements but outreach performed by the Boards has indicated that these adjustments made by analysts have contained assumptions that are highly inaccurate. Among other things, Bank lending departments should consider the following action items:
• Relationship managers should begin immediately to discuss with borrowers the effect that the proposed changes will have on the borrowers’ financial statements
• Financial covenants, which are one of the more important sections of the loan agreement, will likely be impacted by the changes to the borrowers’ financial statements
• Debt to equity, EBITDA and other ratios will change and may cause non-compliance with financial covenants
• Lending departments should anticipate these effects and have a plan in place to address these compliance issues
• Changes to borrowers’ financial statements will affect how the risk of the loan relationship is rated in the bank credit assessment process. Risk managers should anticipate this issue and have a plan in place to address the implications
The Bank as a Lessee
Banks that have current lease arrangements at the implementation date will be required to recognize the liability for these leases on their balance sheet. Due to this change banks may experience the following:
• Need to increase regulatory capital amounts
• Impact to capital and leverage ratios
• Changes in leasing strategies
• Future tax implications
Recommended Next Steps
It is easy to become complacent in preparing for the changes that will be finalized on January 1, 2019. Timely preparation is the key to an effective implementation. Summarized below is just a partial list of next steps that banks should be considering in preparation for the lease accounting changes.
1. Increase Internal Communication.
Make sure that bank lending department management is aware of the proposed accounting change so that the impact to lending relationships and financial covenants of lending agreements can be assessed, along with loan risk rating procedures.
2. Evaluate Current Procedures and Systems.
The issues that must be considered are more numerous and complex than under the current accounting standards and require a complete understanding of all of the terms of the lease. In addition, the reassessment requirements are much more rigorous. Remember that existing leases at the time of adoption will not be grandfathered. It is critical that the terms of each lease be documented clearly and consistently in a manner that allows for ready review. Bank lessees should strongly consider the need for a technology solution that captures all of the key provisions of the lease and stores them in an easily accessible format.
3. Review Current Leasing Strategy.
How will your leasing strategy change as a result of the new accounting standards? No one wants accounting implications to drive the economics of the organization but they will undoubtedly be a consideration. Will lease versus buy decisions change? Will lease terms change? Longer lease terms will result in larger liability balances, however, shortening lease terms, particularly for branch leases, may not be in the best operational interests of the bank.
4. Understand Impact to Financial Reporting.
Financial statement analytics will change dramatically. Banks should consider the implications on among other things, debt covenant compliance, employee compensation plans, contractual agreements and other key legal documents. Determining the impact of the proposed changes on overall capital levels and capital ratios will be extremely important for productive discussions with bank regulators and analysts.
5. Review Potential of Tax Implications.
Income tax policy is unlikely to change as a result of the proposed accounting changes, therefore, book-tax differences will likely increase and result in a more complex tax computation.