New Lease Accounting: Top 10 FAQs Surrounding ASC 842

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What seemed like a topic that was always in the distant future is now upon us: accounting standards update (ASU) No. 2016-02, Leases(ASC 842). 

Under previous rules, lessees typically accounted for lease transactions as off-balance sheet operating leases or on-balance sheet finance leases. Under the new standard, lessees will have to recognize nearly all leases on the balance sheet. 

ASU 2016-02 comes on the heels of Revenue Recognition (ASC 606) and presents another wide-reaching and major change to the accounting world. Under ASU 2016-02, balance sheets will swell as nearly all leases will now be capitalized. Overall the ASU is very complex; however, below are some frequently asked questions that we are seeing from our clients and the industry. Like most things, the devil is in the details, but the below Q&A can provide high-level answers to these burning questions.

1. When is the standard effective?

ASU 2016-02 is effective for public companies in 2019 and private companies in 2020.

2. What are the changes to how capital leases (now known as “finance leases”) are presented?

The general accounting for finance leases remains largely unchanged compared to the legacy presentation of capital leases.

On the balance sheet, the finance leased asset is typically recorded as part of property, plant and equipment (PP&E), and the lease liability is recorded as funded debt. From a profit and loss perspective, the leased asset is depreciated over the shorter of the term or asset’s useful life, and interest expense is front-loaded as the lease obligation is amortized.

3. How will operating leases now “look” on the balance sheet?

Operating leases take on an entirely new look under ASC 842 in that a right-of-use (ROU) asset and liability are recorded by calculating the present value (PV) of the lease payments using the appropriate discount rate.

Balance sheet presentation of a ROU asset is classified as a long-term asset on a separate line item outside of PP&E. Furthermore, the ROU lease obligation will need to be separated into short-term and long-term liabilities that are aside from funded debt. The profit and loss components of a ROU asset and corresponding liability are amortized under the straight-line method and presented together as rent or lease expense.

Under ASC 842, neither amortization of the ROU obligation nor the ROU asset is considered interest expense or depreciation expense, leaving EBITDA unchanged from accounting for operating leases under the prior lease standards. 

4. Does the standard change the way we determine which type of lease we have?

There will continue to be two types of leases: finance (formerly known as capital) and operating. However, both will require recognition of an asset and a liability on the balance sheet. The differentiation between the two types of leases will play a significant role as to balance sheet classification but does not come without significant analysis in determining what type of lease it actually is.

Finance leases will no longer be evaluated using the “bright-line” tests. Rather, they will be evaluated using principles-based criteria, which aim to evaluate the underlying substance of the lease. The principles-based criteria certainly involve a level of subjectivity; however, the finance lease classification applies should any of the following be met:

  • The property transfers to the lessee at the end of the lease.
  • The lessee is reasonably certain to exercise a purchase option.
  • The lease term is for a “major” part of the asset’s economic life.
  • The present value of lease payments equals or exceeds “substantially all” of the fair value of the asset (undoubtedly the most subjective — more on this later).

If the lease does not meet the above criteria, it will be considered an operating lease. 

5. What changes for lessors vs. lessees?

From the lessor’s point of view, not much changes. In contrast, lessees will now be required to capitalize all leases with terms greater than 12 months.

6. Why is the FASB doing this?

Think about this: Prior to this standard, airlines had not been recording their airplanes on their balance sheets! The standard provides better clarity to users of the financial statements via recognition and measurement of a company’s leased assets and associated liabilities that have historically been tucked away in a footnote disclosure.

7. How do I determine the discount rate?

This is where things can get tricky! To determine the PV, lessees should use the implied rate in the lease contract (if known) or the company’s incremental borrowing rate. This rate is based on what rate the company would obtain if financing 100% of the underlying asset using similar terms and pledging the asset as collateral. 

Knowing that this is often difficult to determine, private companies are afforded an election to use the risk-free rate (e.g., Treasury bill). However, this comes with caution as it typically results in a higher PV, leading to a larger corresponding asset and liability to be booked.

8. Are there new disclosures required?

The footnote disclosure under current standards doesn’t afford financial statement users with many details on either type of lease; however, this is changing. Under ASC 842, the disclosure will provide the reader with both quantitative and qualitative information as to how the lease classification was determined. This information will help the reader comprehend significant judgments and assumptions that were used in evaluating leases under the principles-based criteria.

9. How will this impact my loan covenants?

With operating leases now on the balance sheet, various financial metrics, including those commonly used in loan covenants, are sure to change. The measures of working capital, quick ratio, current ratio and any metrics related to debt (i.e., funded debt) will need to be reviewed carefully to understand how newly capitalized leases will influence results.

In calculations involving EBITDA, the change should not impact results as interest and depreciation (associated with finance leases) are added back, and operating leases (presented as rent or lease expense) are commonly excluded from the benchmark.

Needless to say, it will be imperative to be proactive with your banker. Covenants should be analyzed to determine the impact of the new standard. Some lenders are changing agreements to use updated metrics, while some are simply adding wording to the covenant calculation that says, “Under GAAP in place as of the date of this agreement.” That may seem to simplify things; however, it may also require you to keep two sets of books and records, which can get complicated.

10. How do I prepare for these changes?

The first step is to digest the change in standards and the ripple effect that will come from capitalizing substantially all leases. This will involve an evaluation of the appropriateness of systems, procedures and controls necessary to accumulate and track pertinent lease information. Determination will need to be made as to adoption of ASC 842, which is available on a modified retrospective basis or through a cumulative effect adjustment as of the beginning of the year of adjustment.

A proactive approach to the change in lease accounting is certain to help reduce the burden and headaches of another significant change in accounting standards. If you haven’t done so already, you should start your process in a variety of ways, including knowledge transfer sessions, the evaluation of lease contracts and interpreting the impacts on financial statement presentation and disclosures.



Kaufman Hall: Hospitals saw profitability bump in October, boosted by rise in volume

A bar chart showing positive business growth

Hospitals saw a profitable October, spurred by a boost in volume and length of stays, according to a new report. 

Kaufman Hall’s latest flash report, based on financial data from 600 hospitals in October, showed improved performance in both operating margin and EBITDA compared to September and to October 2017.

Year-over-year EBITDA margin improvements were reported across the country, aside from the Northeast and mid-Atlantic, with the greatest gains reported in the Midwest. Midsized hospitals with between 200 and 300 beds made the greatest profitability gains, while large hospitals with 500 or more beds struggled to manage costs as effectively, according to the report.

“For Halloween, October delivered a treat rather than a trick for hospitals,” Jim Blake, managing director and publisher at Kaufman Hall, wrote in the report.

A major source of the improvement, according to the report, was a 15.8% month-over-month increase in operating room minutes. Kaufman Hall’s team found a 5.2% increase in discharges and a 3.6% increase in emergency department visits. 

Though October’s results were positive, the analysts say it’s hard to determine whether one month of gains portends a longer-term rebound. But in the short term, Kaufman Hall does predict a strong December compared to the year before, though it could trail October and November’s figures.

As increased volume also means increased labor and supply costs, the report additionally spotlights the role the Centers for Medicare & Medicaid Service’s expansion of cuts to 340B discounts could play in the profitability discussion for 2019.  

In late 2017, the agency finalized changes to the drug discount program’s payment rate, cutting it to 22.5% less than the average sales price for a drug. For 2019, CMS will expand those changes from hospitals to off-campus provider facilities, which will naturally tighten belts further, according to the report. 

The decrease in payments is likely to be less than the $1.6 billion culled from the program in 2018, according to the report, but it does mean hospitals should be paying close attention to how their outpatient and ambulatory facilities prescribe 340B drugs. 

It’s especially crucial to be vigilant, according to the report, as it’s likely CMS is considering other changes in this vein, and commercial payers follow the feds’ lead.

“The new CMS rule on 340B drugs is a sign of things to come, and healthcare leaders should be alert to such changes,” according to the report. “The federal government is likely to challenge any lines of business in which hospitals and health systems make significant margins.” 




CHS sees massive Q3 net loss amid weak volume, aftershocks of HMA settlement

Credit: Rebecca Pifer / Healthcare Dive, Yahoo Finance data


Dive Brief:

  • Community Health Systems reported third quarter net operating revenues of $3.5 billion, a 5.9% decrease compared with $3.7 billion from the same period last year but slightly higher than analyst expectations.
  • In its earnings release after market close Monday, the Franklin, Tennessee-based hospital operator also disclosed a massive shareholder loss in the quarter of $325 million, or $2.88 per diluted share. CHS had a net loss of $110 million, or $0.98 per diluted share, in Q3 2017.
  • Lower volume was partially to blame, as the quarter saw a 12.4% decrease in total admissions and a 12.2% decrease in total adjusted admissions compared with the same period in 2017. The report also pointed the finger at the financial aftershocks of its troubled purchase of Health Management Associates (HMA), along with loss from early extinguishment of debt, restructuring and taxes.

Dive Insight:

CHS, one of the largest publicly traded hospital companies in the U.S., reported its highest operating cash flow since the second quarter of 2015, according to Jefferies. The third quarter figure of $346 million is also significantly higher than the $114 million from the same quarter last year.

Similarly, volume and revenue didn’t tank as heavily on a same-store basis as they did overall. Same-facility admissions decreased just 2.3% (adjusted admissions by 0.8%) compared with a year ago. Net operating revenues actually increased by 3.2% during the quarter compared with last year, beating analyst expectations.

But declining admissions show how hospital operators continue to struggle under the fierce headwinds 2018 has blown their way so far. CHS is clearly not immune, as the 117-hospital system faces ongoing operational challenges, bringing in financial advisers earlier this year to restructure its copious long-term debt.

The 20-state hospital operator continues to deal with the fiscal fallout from its roughly $7.6 billion acquisition of Florida hospital chain HMA in 2014. The Department of Justice accused the 70-facility HMA of violating the Stark Law and the anti-kickback statute for financial gain between 2008 and 2012, activities CHS reportedly was aware of prior to the merger.

Just last month, CHS announced a $262 million settlement agreement ending the DOJ investigation into HMA’s misconduct. However, that liability was adjusted during the third quarter and, taking into account interest, now totals $266 million. The fee will reportedly be paid by the end of this year.

The settlement also slapped an additional $23 million tax bill on the 19,000-bed system under recent changes to the U.S. tax code.

But that’s not the only regulatory brouhaha CHS has dealt with this quarter.

Since August, CHS has been under civil investigation over EHR adoption and compliance. Annual financial filings show that the company received more than $865 million in EHR incentive payments between 2011 and 2017 through the Health Information Technology for Economic and Clinical Health Act, payments that investigators believe may have been overly inflated.

To deal with the burden, CHS has continued its portfolio-pruning strategy into the third quarter (although a recent Morgan Stanley report notes the system has a very high concentration of weak facilities, and those at risk of closing, relative to its peers). 

During 2018 so far, CHS has sold nine hospitals and entered into definitive agreements to divest five more. The earnings report also divulged CHS is pursuing additional sale opportunities involving hospitals with a combined total of at least $2 billion in annual net operating revenues during 2017, taken in tandem with the hospitals already sold.

The ongoing transactions are currently in various stages of negotiation, the report notes, but CHS “continues to receive interest from potential acquirers.”

CHS is cast in a better light when balance sheet adjustment and non-cash expenses are discarded, as well. Adjusted EBITDA was $372 million compared with $331 million for the same period in 2017, representing a 12.4% increase and suggesting the company can still generate cash flow for its owners in a more friendly atmosphere than the one Q3 provided.

But, though Q2 results were a bright spot in an otherwise gloomy year for the massive hospital operator, its shares have lost about 30% of their value since the beginning of the year (compared to the S&P 500’s decline of roughly 0.5%).

Jefferies believes that CHS should improve its balance sheet and drive positive same-store volume growth, along with speeding up divestitures to raise cash to pay down debt, in order to improve its stock performance.



450 hospitals at risk of potential closure, Morgan Stanley analysis finds

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More than 15 percent of U.S. hospitals have weak financial metrics or are at risk of potential closure, according to Business Insider, which cited a recent report from Morgan Stanley.

Morgan Stanley analyzed data from more than 6,000 hospitals and found 600 of the hospitals were “weak” based on criteria for margins for earnings before interest and other items, occupancy and revenue, according to Bloomberg. The analysis revealed another 450 hospitals were at risk of potential closure, according to Business Insider

Texas, Oklahoma, Louisiana, Kansas, Tennessee and Pennsylvania had the highest concentration of hospitals in the “at risk” pool, according to the report.

Industry M&A may be no savior as the pace of hospital closures, particularly in hard-to-reach rural areas, seems poised to accelerate.

Hospitals have been closing at a rate of about 30 a year, according to the American Hospital Association, and patients living far from major cities may be left with even fewer hospital choices as insurers push them toward online providers like Teladoc Inc. and clinics such as CVS Health Corp’s MinuteClinic.

Morgan Stanley analysts led by Vikram Malhotra looked at data from roughly 6,000 U.S. private and public hospitals and concluded eight percent are at risk of closing; another 10 percent are considered “weak.” The firm defined weak hospitals based on criteria for margins for earnings before interest and other items, occupancy and revenue. The “at risk” group was defined by capital expenditures and efficiency, among others.

The next year to 18 months should see an increase in shut downs, Malhotra said in a phone interview.

The risks are coming following years of mergers and acquisitions. The most recent deal saw Apollo Global Management LLC swallowing rural hospital chain LifePoint Health Inc. for $5.6 billion last month. Apollo declined to comment on the deal; LifePoint has until Aug. 22 to solicit other offers. Consolidation among other health-care players, such as CVS’s planned takeover of insurer Aetna Inc., could also pressure hospitals as payers push patients toward outpatient services.

There are already a lot of hospitals with high negative margins, consultancy Veda Partners health care policy analyst Spencer Perlman said, and that’s going to become unsustainable. Rural hospitals with a smaller footprint may have less room to negotiate rates with managed care companies and are often hobbled by more older and poorer patients.

Also wearing away at margins are technological improvements that allow patients to get more surgeries and imaging done outside of the hospital. They are also likely to be forced to pay more to attract and retain doctors in key areas, Bloomberg Intelligence analyst Jason McGorman said.

They “are getting eaten alive from these market trends,” Perlman cautioned.

Future M&A options could be too late — buyers may hesitate as debt laden operators like Community Health Systems Inc. and Tenet Healthcare Corp. focus on selling underperforming sites to reduce leverage, Morgan Stanley’s Zachary Sopcak said.

The light at the end of the tunnel is some hospitals are rising to the occasion, Perlman said. Some acute care facilities are restructuring as outpatient emergency clinics with free-standing emergency departments. “Microhospitals,” or facilities with ten beds or less, are another trend that may hold promise.


The fuzzy math around Community Health Systems’ hospital sales

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Community Health Systems, the struggling for-profit hospital company, recently conducted a 30-hospital fire sale to reduce its massive debt load. Top executives routinely said in earnings calls with investors they were selling “unproductive” hospitals for “outstanding prices.”

What we found: An Axios analysis finds that, for at least some of those facilities, the numbers don’t really match what executives said. CHS appears to have sold several profitable hospitals for below-average prices.

Why it matters: The discrepancy between CHS’ words and actions raises questions. If CHS sold profitable hospitals for low prices, the company could continue to struggle paying down its mountain of debt because it will have fewer facilities to generate cash. Some investors already believe CHS could default on its debt.

The background: Hospitals are often sold based on a measure of profitability called earnings before interest, tax, depreciation and amortization, or EBITDA. Prices vary based on location, profit, insurance contracts and other factors, but the average hospital today could be sold at 8.5 times its EBITDA, according to one industry estimate.

CHS CEO Wayne Smith and former CFO Larry Cash both have frequently said during earnings calls over the past 18 months the company was getting rid of low-performing and low-margin hospitals. Smith also declared CHS was getting “attractive prices” and “very good value for the facilities that we’re selling, and we’re getting about 10 times (EBITDA) in a market for single-digit (margin) hospitals.” Smith later said “the multiple from our 30-hospital divestiture plan is approximately 12 times EBITDA.”

The gritty details: Eight of the 30 hospitals in CHS’ fire sale are in two states, Pennsylvania and Washington, that have reported financial statements to the public. And the numbers don’t line up with what Smith and Cash said. Here’s the quick synopsis of our analysis, which focused on deals that had publicly announced financial terms:

  • CHS sold four hospitals in Pennsylvania to PinnacleHealth for $231 million, or 3.4 times operating earnings. That multiple would have been even lower if the Pennsylvania data excluded interest and depreciation.
  • CHS sold two hospitals in Washington to Sunnyside Community Hospital for $45 million, or 5.3 times EBITDA.
  • CHS sold two hospitals in Washington to MultiCare Health System for $424 million, or 7.2 times EBITDA.
  • None of those deals are close to the prices that CHS executives discussed publicly.

CHS had a few gripes with the analysis:

  • The Pennsylvania data is based on a July 1 to June 30 fiscal year instead of the typical calendar year that CHS reports.
  • Neither state includes the financial impact of physician practices and other ancillary services.
  • Smith said the multiple from the entire 30-hospital divestiture plan, including working capital, was 12 times EBITDA. That means “some of the transactions were above 12 times, and some were below.”
“The Community Health Systems management team has made accurate and appropriate disclosures about our divestitures,” spokeswoman Tomi Galin said several times during a three-week email exchange. CHS declined to provide the audited data it used for the hospital transactions, and executives were not made available for interviews.
Yes, but: The analysis was shared with a few industry experts who have experience with hospital transactions and spoke on background. They didn’t believe CHS’ points made a material difference. “You’re not going to get a 12-times multiple for something that’s debt-laden,” one hospital finance expert said.
Another industry source said it’s “a little fuzzy sometimes to figure out exactly what the EBITDA is and what the multiples are.” But the numbers CHS executives were citing “just aren’t seen often,” the source said. Getting anything above 12 times EBITDA is almost unheard of for most hospitals right now and highly unlikely in these cases, the experts said.

Underlying concern: Although CHS defended the statements and numbers from earnings calls, some people who follow the company believe the discrepenacies are representative of a long pattern. “There’s a history of deceptive communication practices,” said one CHS investor, who asked not to be named given the sensitivity of the issue.

What to watch for: How much debt CHS still has at the end of the third quarter, and what executives tell investors about the status of the company.