New accounting standards on leases could hit some banks' capital and require them to re-evaluate the leverage of their borrowers.
Under a new rule from the Financial Accounting Standards Board, financial statements will soon place leased items like branches, cars and office equipment on the balance sheet as assets. This has special implications for banks and credit unions, which will need to offset these assets with risk-weighted capital. They will also need to revisit what is an acceptable leverage ratio for borrowers as they update loan agreements.
This change comes as many industries, including banks, are grappling with other substantive changes, and accountants and auditors worry that it may not be getting the attention it deserves.
The accounting change is intended to give investors a better sense of a company's leverage, said Michael Gullette, senior vice president of tax and accounting at the American Bankers Association. As payments, operating leases are a factor in a company's leverage; rating agencies often used an estimation of a company's operating leases in their estimation of a company's creditworthiness. For banks, the change will impact both their and their borrowers' financial statements if they lease equipment — metrics that could change include the leverage and debt-to-equity ratio, net income, return on assets and operating cash flow, according to the ABA's primer on lease accounting.
The change has special implications for banks. Like any asset, banks will need to risk-weight the leases that have been added to their balance sheet and add it to their capital cushion; prudential regulators recently indicated that it should be 100%. The June 2017 Supplemental Instructions said to the extent a bank has a "right-of-use" asset stemming from a leased tangible asset, that asset should be treated as a "tangible asset not subject to deduction from regulatory capital." It also must be included in the calculations of total risk-weighted assets and total assets for leverage capital purposes.
"We have bank clients at our firm that lease a lot of branches, so it could have a significant impact," said Tracy Harding, principal at accounting and consulting firm BerryDunn. "We've been talking to community banks about including that in their capital modeling."
The capital hit to the industry is uncertain, Gullette said, mostly because there are no good numbers about how many operational leases are on banks' books. He said the call reporting offers "pretty nebulous" figures that don't provide enough detail, but some banks already report there could be a substantial impact. Fifth Third Bancorp said "the effects of recognizing most operating leases on the Condensed Consolidated Balance Sheets are expected to be material" in its first-quarter Form 10-Q.
Adding operational leases onto the balance sheet could also have implication for leaseback transactions, where a company like a bank sells a property it owns and then immediately leases it back from the new owner. Harding said it could make leasing "more neutral" when banks are assessing the costs and benefits of leasing compared to buying, but he does not think the change would impact overall branching trends or considerations.
Banks will also need to revisit their lending agreements and contracts with borrowers to account for the updated financial information. Banks will need to update their borrowers' debt covenants so that they do not violate the terms when the change goes into effect.
"[Banks] may have borrowers that would fail the current covenant but nothing's really changed," said Harding. "They're leasing the same space they were before, but the covenant may need to have a fresh look."
Banks use the debt covenants as an "early warning signal" for credit weakness, said Michael Lundberg, national director of financial institutions services at audit firm RSM. They often submit a violated debt covenant through the approval same process that was used during underwriting. Additionally, he said revisiting debt covenants with borrowers' updated financial information will also create a broader, more "conceptual" question for banks, he said: "What is a leverage ratio that we're comfortable with?"
While this could be an undertaking for a bank with many borrowers that lease equipment, Gullette said he expected banks would want to keep the customers and loans, and that some may already have adopted this approach during underwriting.
"Depending on the customer, banks [might] already use a short-cut method in order to figure out what that leverage was or would be," he said.
One challenge for banks and borrowers is that the relatively straightforward lease accounting change comes at a time of other accounting overhauls. For banks, their attention may be more focused on the massive accounting shift that awaits them with the current expected credit loss standard; for their borrowers, they may be focused on the reporting changes associated with the revenue recognition standard, said Steven Kirn, audit partner at RSM focused on real estate and construction and financial services.
"I've had many robust conversations [with my clients] that, yes, they need to contact their lenders and talk about revamping the criteria that is being used for the covenant," he said. "They agree wholeheartedly, but they're slow to act."