Banks and other companies are about to add billions of dollars in lease contracts to their balance sheets as a new accounting rule takes effect in 2019.
A new rule from the Financial Accounting Standards Board will add leased items like branches, cars and office equipment on the balance sheet as assets and liabilities for all public companies. That will have special implications for banks and credit unions, which will need to offset these assets with risk-weighted capital. The change goes into effect in 2019, which means companies are running out of time to identify, add and offset their lease expenses in company filings and disclosures. The new standard could have further implications on lending later in the year, as financiers recalculate the new leverage limits they will allow borrowers.
The standard required companies to calculate the value of their leases and add it to the balance sheet as a right-of-use asset and a liability separate from other forms of debt. Previously, only lease expenses were recorded on the income statement, even though operating leases can factor into a company's leverage.
William Watts, a principal at Crowe Risk Consulting who leads the accounting advisory services, said companies should implement the standard with a focus on completeness, clarity and control. Financial services companies have struggled with the first area, he said, because of their heavy use of leases.
Banks needed to add up dollar values tied to their leased branch locations, stand-alone ATMs, contracted internet services like servers and cloud storage and office equipment, down to the last water cooler, he said. Like any asset, banks will need to risk-weight the leases they add to their balance sheet; prudential regulators have indicated that it should be 100%.
The biggest banks have millions, sometimes billions, of dollars in off-balance sheet items that will become assets and liabilities next year, but most expect a minimal capital impact. Among the largest banks, JPMorgan Chase & Co. said it expects to recognize $10 billion in lease liabilities and corresponding right-of-use assets for its future minimum operating lease payments, while Bank of America Corp. said it expects to recognize between $9 billion and $11 billion in lease liabilities. Neither bank expects material or significant changes to capital levels, according to their third-quarter filings.
Comerica Inc. said that adding between $450 million and $550 million of leased assets to its balance sheet will lower capital levels between eight and 10 basis points, according to its quarterly filing. Northern Trust Corp. said the standard will have a "significant impact" on its financial condition. Fifth Third Bancorp also said that recognizing between $400 million and $500 million in right-of-use assets and lease liabilities would have a material impact on its balance sheet. It, along with several other companies, will also record deferred gains to retained earnings stemming from previous transactions where a branch was sold and leased it back.
Despite the hit to the balance sheet, the change will have "almost zero impact" on the income statement, Watts said. Many of the largest banks' lease obligations will represent less than 1% of total assets, according to S&P Global Market Intelligence data. Companies will continue recording quarterly lease payment as expenses.
It is still too soon to tell how the leasing standard will impact borrower relationships. The added liabilities to a company's balance sheet may violate debt covenants in borrowing agreements with their lenders if those agreements set a limit on the borrower's liabilities. Watts said some of his clients are in discussions with their banks about their debt covenants, but the banks are still making internal adjustments. He said these changes may become more evident in the second or third quarter of 2019.
The leasing change will move the U.S. accounting standards closer to international ones, an effort called "convergence," Watts said. It will make the financial picture of companies across the globe more comparable.
"Just like any new change of U.S. accounting standards and reporting, it's going be a headache and a pain for everybody for a couple years," he said. "I think people realize it's the proper thing to do. Having off-balance sheet assets is confusing and misleading."