THE GAAP GAP: COMING SOON TO A COMPANY NEAR YOU

Introduction: When Planets Align--The Perfect Accounting Storm?

We survived the Y2K, the 2012 end to the Mayan calendar, the summer solar eclipse, and numerous ominous alignment of planets. Now we face an accounting apocalypse, a debit-credit deluge, a T-account tsunami? Not really.

Accounting was simpler when Fra Luca Pacioli devised debits and credits to keep the Venetian Naval yard books shipshape in the 15th century. Since then, his invention has evolved here in the USA into a complex set of generally accepted accounting principles (GAAP) under the management of the Financial Accounting Foundation (FAF)’s Financial Accounting Standards Board (FASB).

The old Chinese curse, “May you live in interesting times,” is certainly haunting us now in the wake of the Great Recession, an explosion of Dodd-Frank regulatory expansion, greater worldwide economic and political volatility, and cessation of an accounting convergence project with the International Accounting Standards Board (IASB). In the middle of all this excitement, FASB has put into motion a series of new GAAP standards that will be implemented for public firms in a relatively short period of time—revenue recognition (Rev Rec) after December 15, 2017, lease capitalization (Lease Cap) after December 15, 2018, not-for-profit organizations (NFP) after June 15, 2018, and current expected credit loss (CECL) after December 15, 2019. Rev Rec, Lease Cap, and CECL go into action for privately held firms a year later than for public firms. 

Two of the changes—Rev Rec and Lease Cap-were the final work of the IASB and the FASB trying to bring their respective International Financial Reporting Standards (IFRS) and GAAP closer together, but the two organizations agreed that they were as close together as they were likely to get given the economic and legal differences between the rest of the world and the USA. Both standards had been deferred by FASB from implementation at the request of US business interests, but FASB finally drew a line in the ledger, and so here we are. Consider this piece a wake-up call; the CFO and the accounting department of your company, your favorite NFP, or your borrower are in for challenging nights. So, as Bette Davis warned in All About Eve, “Fasten your seatbelts. It’s going to be a bumpy night,” for the next several years

Summary of the New Standards

Revenue Recognition. Not so long ago, US accounting offered over 100 different ways to recognize revenue based on unique industry issues. The IASB convinced FASB that there really needs to be only one way, and that is when a “transfer of control” occurs between seller and buyer. The simplification is trickier than it looks because it requires separation of the product, extended warranties, installation, training, and other services if they have different times in their recognition. Disclosure will necessitate much more detailed footnotes to explain the quantitative and qualitative information the nature, amount, timing, and any uncertainties relating to revenue and cash flows coming from contracts with customers.

Many companies are racing to meet the December 15, 2017 deadline, but are encountering a range of issues—multiple deliverables and performance obligations embedded in their contracts, timing concerns in long-term contracts, net vs. gross revenue recognition, etc. Industries reliant on long-term contracts are most likely to be impacted—software and technology, life sciences, aerospace and defense, cable-media and entertainment. Less affected will be industries with shorter revenue cycles—retailing and distribution. The good news for the long-term revenuers is that cash flow is likely to be collected before the revenues are recognized.

Companies can choose between full restatement or just opting for a one-time cumulative change in their fiscal 2017 statements, but this is the kind of change that credit analysts dread—the historic spreads are no longer comparable.  Other items to watch out for will be more activity in returns and allowances, and service warranties. Analysts will have to dust off their guidance on the difference between gross revenues and net sales.

Not-for-Profit Accounting. Banks lend heavily to NFPs—schools, universities, charities, religious organizations, cultural institutions, trade organizations—but their accounting has always been primitive as a whole. For the first time in two decades, FASB decided it was time to bring NFP’s into this century, effective with fiscal years beginning July 1, 2018.

First, FASB has reduced the number of asset classes to just two; net assets with donor imposed restrictions will replace temporarily and permanently restricted categories. The differences will be relegated to a footnote. The unrestricted category will be renamed “net assets without donor restrictions.” 

Second, NFP investment return is to be net of related internal and external expenses. Third, expenses are to be classified by nature and function, which will help identify whether expenses are fixed or discretionary. Fourth, more disclosure of NFP liquidity is required, specifically, how much is available to cover the next 12 months. Finally, besides donor restrictions, the financials will have to disclose Board restrictions on funds.

Lease Capitalization. For many years, lenders have been frustrated by leasing’s off-balance sheet obscurity. Sure, we put it back on the balance sheet by capitalizing the annual lease and rent expense via some multiplier, say 5x or 6x. Wouldn’t it be nice if the accountants would do that for us? Good news—after December 15, 2018, the accountants will capitalize all leases, regardless of size, with a term of more than one year. Even better, not only will the lease liability pop up on the right side of the balance sheet, the leased asset will materialize on the left side as a right-of-use (ROU) asset.

Although the IASB elected to permit only capital leases, FASB decided to permit both capital leases and operating leases. Capital or financing leases, called Type A leases, amortize like a car loan, i.e., level principal and interest (P+i) and are to be used for non-real estate assets. Operating leases, called Type B leases, will amortize on a straight-line basis, so real estate leases will show a declining interest expense as the lease pays down.

Retailing, transportation, and the travel & leisure industries are likely to be most affected by Lease Cap because of their reliance on leased assets. Banks are also going to have to decide whether their branch leases are worth the additional regulatory capital that putting the branch ROU assets back on the balance sheet will require. Watch the steady decline in branches and figure that some of the closures are not because millennials prefer to bank with their cell phones rather than visit brick-and-mortar branches.

Lenders should be aware that debt/worth debt/EBITDA ratios are likely to rise under the new Lease Cap standard, so they should be prepared for possible borrower requests for leverage covenant upward adjustments. Keep in mind the impact on EBITDA as rent and lease expense reduce it but interest and amortization do not.

Current Expected Credit Losses (CECL). CECL is not just a change for banks: it is applicable to any entity that offers credit terms longer than a year, and at this time, CECL is expected to go live after December 15, 2019. Banks are being given a couple of extra years, 2020 for bigger banks and 2021 for community banks, generally speaking. Credit extenders will have to estimate potential loss at the inception of the transaction based on the life of the loan. Generally speaking, bank practice has been to estimate the potential loss every 12 months or so, and that allowed banks to adjust the probability as circumstances change. Many smaller banks do not have the data to estimate the probability of loss for longer amortizations, especially mortgage amortizations of 10, 15, or 30 years. Further, probability of default data tends to be non-linear as the length of the exposure increases, and so the immediate charge to earnings will be higher. Compounding the transition is that the 2019 implementation date is likely to be during a recession, given that at this writing, the current economic expansion is now in its eighth year and unlikely to continue another 2 years into 2019.

Regardless of the implementation challenges, it will force long-term creditors to build up their reserves against losses, and most agree that is the right thing to do. Meanwhile, the Risk Management Association has already begun to offer industry loss data to banks who do not yet have their own information, and the regulatory agencies have been working with FASB to moderate industry concerns.

Summary and Closing: GAAP Leap Forward or Accounting Apocalypse?

Abe Lincoln observed, “When you reach the end of your rope, tie a knot and hang on.” After years of discussion and debate and deferral, FASB tied the knot, and four new standards finally are coming on line for publicly traded companies—privately held firms the following year-- over the coming years—Rev Rec after 15 December 2017, NFP accounting changes effective 1 July 2018, Lease Cap after 15 December 2018, and CECL after 15 December 2019. Privately held firms get an extra year to get their act together. Rev Rec has put many firms under pressure to meet the 2017 deadline, and that means Lease Cap is going to be that much more stress on firms. Of course, NFPs have both their own accounting changes to implement, but they are also likely to be impacted by Rev Rec and Lease Cap, too. By the time CECL rolls around, accountants may well deserve some R&R. No one intended that these new GAAP standards hit the books so closely together, but bankers, lenders, and other credit extenders should be aware that big changes are coming to GAAP. The point of this summary has been to alert you to this impending great leap forward and to help you bridge the gap from old to new GAAP. Take heart in George Carlin’s observation on things to come, “The future will soon be a thing of the past.”