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Hospital and Health Care Industry Implications

All industries will be impacted by the issued changes in lease accounting but the extent of the impact will to a great degree depend upon individual company circumstances. But certain industries rely on leasing, particularly leases classified as operating leases, to a greater extent than other industries and the Hospital and Health Care Industry falls into that category.

In the area of real estate holdings, there has been a clear change in Hospital business strategy over the last few years to expand outpatient surgical centers and medical office facilities outside the core hospital footprint and more into the suburban office environment. This has created an incentive for real estate operators to construct new facilities or convert existing real holdings into medical office or outpatient surgical centers. Virtually all of this activity has been done through medium term (five to ten year) operating leases that allow the lessee to avoid recognizing the lease obligation as a liability on its financial statements and making expensive investments in fixed assets.

As to equipment, in any visit to a medical office or outpatient surgical center, it is clear that numerous pieces of medical equipment, some of which are extremely sophisticated, are required for successful operation. Operating lease financing facilitates the acquisition of this type of equipment since it requires minimal upfront cash outlay and passes the risk of equipment obsolescence, which in many cases is significant, back to the lessor after the conclusion of the lease term. The net effect of the new lease accounting standard will be a major increase in liabilities that must be recorded on the balance sheet of the lessees and a negative impact on debt to equity ratios. For many hospitals which have bond financing and related restrictive financial covenants, any increase in liabilities could present a particular challenge and may well require a waiver discussion with the lender. Certainly, lease versus purchase analyses will become more important and could result in a decrease in leasing activity. But it is difficult to envision any significant decrease in leasing for a number of reasons.

• Hospitals are generally cash strapped and leasing presents a particularly advantageous form of financing for those organizations that want to minimize upfront cash outlays.
• Leasing of real estate allows health care organizations the flexibility to relocate to another location after the term of the lease, possibly to a more advantageous location. Owning real estate may well inhibit this flexibility.
• Purchasing medical equipment requires an initial cash outlay along with a financing arrangement and vests the owner with the risk of obsolescence – not a particularly attractive alternative.

To be sure leasing strategy may change, particularly for real estate leases. Shorter term leases will result in smaller liabilities that must be recorded. But there is a business trade off. Shorter term leases mean more frequent lease renegotiation risk with the possibility of prime real estate locations becoming more expensive. What can Hospital and Health Care Industry executives do now to prepare for these changes?

Presented below is a partial list of actions steps that should be considered immediately.

• The issues 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 are 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. Health Care 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.

• How will leasing strategy change as a result of the new accounting standards, if at all? Leases consummated now may well have to be transitioned to the new accounting standard. No one wants the accounting implications to drive the economics of the organization but they will undoubtedly be a consideration. We mentioned these issues previously. Will lease versus buy decisions change? Will lease terms change? Longer lease terms will result in larger liability balances; however, shortening lease terms may not be in the best operational interests of the organization.

• Financial statement analytics will change dramatically. Health Care Organizations 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 these critical financial metrics at an early date will allow for timely planning and discussions with interested parties.

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