Banks are bracing for the impact — on two fronts — of a new federal rule that will change how companies account for the cost of leasing everything from equipment to automobiles to space in office buildings or shopping centers.
Under the new rule, which takes effect for public firms on Jan. 1 and for private firms a year later, the Financial Accounting Standards Board will require companies to record operating leases as both liabilities and assets on their balance sheets. As it stands, these costs are kept off the balance sheet, leaving investors with an incomplete picture of a company’s financial obligations, according to FASB.
The change could affect banks in two big ways.
First, they will need to take into account all these new leases on corporate balance sheets when assessing clients' financial positions and ability to repay loans, said Matt Shoemaker, an accountant at Porter Keadle Moore in Atlanta.
“It’s really going to affect how clients classify leases and it could affect their cash flows,” Shoemaker said. “Hopefully it’s going to give banks a better understanding of what’s going on” with their clients’ revenue streams and fixed expenses.
Additionally, banks themselves will see their own balance sheets swell with the new recognition of operating leases — a change that is expected to reduce capital ratios at most banks.
JPMorgan Chase, for example, estimated that its balance sheet
Companies have not been required to disclose detailed financial information about the nature of their lease obligations, but a few banks have.
In its most recent 10-Q, Commerce Bancshares in Kansas City, Mo., said that it has roughly 200 lease agreements in place, though it did not specify if those leases were for real estate or equipment. Commerce estimated that its future minimum lease payments for those 200 agreements is about $34 million.
Commerce also said that it’s in the final stages of installing and testing a new software system to handle the complexities of the new lease accounting rule.
Banks will be required to record its leases as both a liability, to represent their legal obligation to make lease payments, and an asset, which will represent a bank’s legal right to use the leased office or equipment. The addition of assets to the balance sheet is what could lead to a potential decline in common equity Tier 1 capital ratios.
The new lease rule marks a major change to lease accounting standards that have been in place since 1976.
It is one of two major changes to accounting procedures on tap that will directly affect banks. Banks are also examining potential changes to how they account for estimated loan losses, as a result of the
When the new lease rule takes effect in January, corporate balance sheets will immediately swell with liabilities. For companies like Walmart that lease hundreds of millions of square feet of real estate, the surge of liabilities could be dramatic.
“Operating leases can exert the same pressure as traditional debt financing on a company’s financial resources,” the debt rating agency DBRS said in an October report.
Still, the accounting change doesn’t mean that a bank customer’s underlying economic fundamentals have changed, or that it's suddenly a bigger credit risk, Shoemaker said.
“This is not all new debt that’s appearing out of thin air,” he said. “They’ve been paying these leases for years.”
Yet banks must account for this dramatic change in how their clients’ balance sheets appear. Banks should review all loan documents, and rewrite them if necessary upon maturity or renewal, to prevent unintended violations, said Ane Ohm, CEO of LeaseCrunch, a Milwaukee firm that makes lease accounting software.
A common covenant in bank loans is a requirement for the client to maintain a specific ratio of debt to cash flow, Ohm said. If debt levels increase past a certain threshold, that could violate the covenant, she said.
It may be necessary for a bank to increase loan-loss reserves, or even raise loan rates, to account for the fact that clients will have elevated liabilities, Ohm said.
“Banks are going to be getting new information about their clients and they’re going to use it,” she said.
But Mike Gullette, senior vice president of tax and accounting at the American Bankers Association, said that many banks already try to estimate a borrower’s lease-related liabilities when they underwrite loans and include that estimate in their calculations for reserves.
“Since banks have normally been using shortcut approaches to measure the lease impact, when appropriate, we do not expect any increase in reserves,” Gullette said.
The best strategy for any bank to pursue is to discuss the implications early on with large borrowers, Shoemaker said. Even though the new rule shouldn’t lead to loan defaults, bankers need to address the potential for loan covenant violations far in advance of the maturity date, he said.
“The biggest piece of this needs to be communications,” he said. “Banks need to communicate with their auditors and with their clients. You can’t just call up a client and say, ‘Your liabilities have increased and we’re calling your note.’ ”
As for banks themselves, the change will require them to treat an operating lease as both a liability and as a corresponding asset (because the bank is using the real estate or property it is leasing).
Banks with large branch networks or expansive holdings of real estate in the form of operations centers may see a significant increase in the amount of risk-weighted assets on their balance sheets. Still, it’s not likely that the changes will be financially material to any bank’s results, according to Jason Goldberg, an analyst at Barclays.
“We believe the balance sheet impact should be quite manageable for our coverage universe,” Goldberg, who covers large and regional banks, wrote in a Nov. 19 report.
“Operating leases commitments represent just 0.4% of the median bank’s total assets,” Goldberg said.
Banks in Goldberg’s coverage universe will see a median decrease of 7 basis points in its common equity Tier 1 ratio. The impacts will range from a decline of about 12 basis points for Northern Trust, to about 3 basis points each for Ally Financial and U.S. Bancorp.
The impact on common equity Tier 1 ratios is estimated by calculating long-term lease obligations as a percentage of total risk-weighted assets. For example, U.S. Bancorp had about $1.4 billion of long-term lease obligations at Dec. 31, representing about 0.36% of total risk-weighted assets.
Some banks have already begun disclosing the estimated impact of the rule change on their capital positions. The $31 billion-asset Valley National Bancorp in Wayne, N.J., said the rule will lower its total risk-based capital by about 10 to 12 basis points, and its Tier 1 capital by about 7 to 9 basis points.
Banks will first report results under the new lease accounting standard in April, when they file first-quarter earnings, Shoemaker said. The first set of audited yearly results under the new standard will appear in 2020, when banks issue their 10-Ks for 2019.
