Financial Accounting Standards Board’s Accounting Standards Codification (FASB ASC 842) and the International Financial Reporting Standards 16 (IFRS 16) represent sweeping changes to the way companies account for leases, and banking is one of the industries that is expected to be impacted most.
While banks play unique roles as both lessors and lessees, as well as users of financial statements, the focus of this blog will be on how banks will be impacted as lessees. We’ll provide a brief overview of what’s changed and highlight potential pitfalls that you need to watch for.
What’s different about the new standards?
Under current GAAP, companies are only required to record their capital leases on the books. Under ASC 842 and IFRS 16, all leases with terms longer than 12 months without a bargain purchase option will be required to go on balance sheet. The new standards also clarify the definition of a lease, and call for more extensive disclosure requirements.
The classification of leases has also changed. The term “capital lease” has been replaced with “finance lease.” To determine whether a lease is classified as operating or finance, there are now five tests that you must complete, an increase from the four tests required under the old standards. It’s possible that leases that you once classified as operating will now be considered finance leases.
To see a more comprehensive overview and example, click here.
Pitfalls to avoid
Banks and credit unions typically have complex business agreements, there are specific pitfalls that you should look out for as you transition to the new standards.
The nuances of real estate leases
Leasing real estate enables you to place branches in shopping centers, grocery stores, and other locations that are convenient for your customers.
However those leases come with some nuances that you must be prepared for. For instance, if you lease a location that has a billboard advertising another business on the side, you need to determine whether or not that part of the building is a separate lease or non-lease component. The same goes for a building with cell towers or satellites on the roof. Those assets aren’t for your use, so you need to evaluate whether they are non-lease components.
The new lease accounting standards also raise questions around easements. According to FASB, easements are defined as “the right to use, access, or cross another entity’s land for a specified purpose.” Under the new rules, easements may also be considered leases or contain leases.
What does that mean for banks? Let’s say you have an ATM located in an office building that is privately owned. Can you or your customers access that office building after hours to get to the ATM? That nighttime access may be considered an easement, and that easement may be considered or contain a lease.
PwC offers some excellent guidance on land easements here.
Where to look for embedded leases
One of the biggest challenges with the new standards is identifying embedded leases, which are leases embedded in service, maintenance, and outsourcing contracts. The nature of these contracts makes it easy to overlook the fact that they contain assets that can be deemed leases under the new standards.
Advertising and mailing agreements
If you’re like most of your peers, direct mail is still a key channel for reaching your customers. It’s common to outsource this function, and with that choice comes questions about whether those agreements contain embedded leases.
Does the contract dictate that a certain printer is dedicated for your company’s use? Are the postage meters you use dedicated solely to your facility? If so, those contracts may contain embedded leases.
You’ll also need to examine your advertising agreements. If the contract gives you the exclusive right to advertise on a specific billboard or on the side of a specific building for a specified period, then it may meet the standards of a lease.
Most banks outsource at least a portion of their data center operations. If your organization is one of them, examine your contract to see if specific servers are dedicated to your business. If so, that contract may contain an embedded lease.
More than likely, you lease your ATMs. That’s easy to figure out but what about the space where the ATM is located? For instance, if you have an ATM located in a retail store or shopping center, you may also be leasing the space that contains the ATM, depending on a number of other factors. Note that this is slightly different from an easement. It all comes down to how the contract is worded.
Physical security contracts
When an employee enters one of your branches, they’re monitored by indoor and outdoor cameras, they turn off the alarm system, and use a badge scanner to access restricted areas. Those cameras, alarm systems, and scanners may be leases that are embedded in your physical security contract.
By preparing for these potential pitfalls and looking for embedded leases in the right places, you’ll be better prepared to make a smooth transition to the new standards. Doing the research and legwork up front will save you from auditing and compliance headaches down the line.
Don’t know where to start? Read this FREE lease accounting transition guide made specifically for financial institutions.