THE IMPACT OF ASU 2016-02 LEASES

Running head: THE IMPACT OF ASU 2016-02 LEASES The Impact of (FASB) Accounting Standards Update ASU 2016-02 Leases Domico Wyatt Professor Alfred Greenfield Financial Accounting May 28, 2018 1 THE IMPACT OF ASU 2016-02 LEASES In response to the long living concern over off-balance sheet leases, The U.S. Securities and Exchange Commission (SEC) released results of the study on accounting for leases in its 2005 “Report and Recommendations Pursuant to Section 401c of the Sarbanes-Oxley Act of 2002 on arrangements with off-balance sheet implications, special purpose entities, and transparency of fillings by issuers” (Bramwell). A staggering finding in the study reported that there “may be approximately $1.25 trillion in non-cancellable future cash obligations committed under operating leases that are not recognized on issuer balance sheets, but are instead disclosed in the notes to the financial statements.” The results of the SEC study lead to recommendations that changes be made to the existing lease accounting requirements. The objective of their recommendation was to improve the transparency in financial reporting regarding companies leasing activities in order to give potential investors and other stakeholders a more accurate view into the lease obligations impact on the balance sheet. Here we will examine the outcomes of that study, analyze the impact of the subsequent FASB filing of ASU 2016-02 on the future of accounting for leases. In an effort to gain specific examples this report will discuss the impact that the new standard may have on Waste Management, Inc., specifically to compare and contrast the impact that new guidance will have on the financial ratios of the company, what accounting changes may be required and ultimately how those changes may affect recommendation of stock analyst once the change is made. In 2006, in response to the SEC’s recommendation the Federal Accounting Standards Board (FASB) together with the International Financial Accounting Standards Board (IASB) board began a joint project to improve the financial reporting of leasing activities in financial reports. In order to obtain input from a wide variety of stakeholders the FASB participated in extensive outreach activities. The initial action was the issuance of the 2009 Discussion paper, THE IMPACT OF ASU 2016-02 LEASES “Leases: Preliminary Views”, followed by the 2010 Exposure Draft, “Leases (Topic 840)” as well as the 2013 Exposure Draft, “Leases (Topic 842)”. This outreach effort resulted in over 1,700 comment letters from various industry financial statement preparers and users from both private and not-for-profit organizations (2009). On February 25, 2016 the FASB issued Accounting Standards Update (ASU) 2016-02. This new guidance requires both publicly traded and private companies to recognize their operating leases on their balance sheet. Prior to the ASU companies were required to include capital or finance leases on the balance sheet, however were able to list operating leases in the notes section of the financial statements. Previous guidance resulted in a distorted view of the company’s true obligations given that leases are a major financial obligation for the majority of large industry businesses. Under ASU 2016-02 all capital leases will be referred to as finance leases and both finance and operating leases will be recognized on the balance sheet. Additionally all leases companies will be required to “recognize a right-of-use asset and a lease liability, initially measured at the present value of the lease payment, in the statement of financial position (Bramwell). The new standard improves understanding and comparability of lessee’s financial statements and further clarifies the definition of a lease to address practice issues within current GAAP and to align concept of control, as used within the definition, more closely with control principle used in revenue recognition and consolidations (ASU 2016-02). ASU 2016-02 will require all public companies to implement the require changes beginning with the first quarter of fiscal year 2019, for most other organizations, the update will take effect in the first quarter of 2020. “The new guidance responds to requests from investors and other financial statement users for a more faithful representation of an organization’s leasing activities,” stated FASB chair Russell G Golden. “It ends what the U.S. Securities and Exchange THE IMPACT OF ASU 2016-02 LEASES Commission and other stakeholders have identified as one of the largest forms of off-balance sheet accounting, while requiring more disclosures related to leasing transactions.” The changes related to ASU 2016-02 will be mostly identifiable by the increases in expense recognition on the balance sheet and the related changes displayed in the related financial ratios of organizations. It is anticipated that reported interest bearing debt, leverage and EBITDA will increase for WM on 2019, for certain industry specific companies this increase will be substantial. Specifically, the new standard requires lessees to recognize on the balance sheet at lease commencement a right-of-use asset, and a corresponding lease liability (ASU 2016-02). After researching ASU 2016-02 and the potential impact on a large company like Waste Management, Inc. (NYSE: WM), it is evident that the new guidance plays are big role in their accounting for leases due to industry in which it operates. Founded in 1971, WM is a comprehensive waste and environmental services company headquartered in Houston, Texas, where they occupy approximately 345,000 square feet under leases expiring through 2020. They offer environmental services to over 20 million residential and 2 million commercial customers throughout the United States, Canada and Puerto Rico. Their operating network includes 367 collection operations, 346 transfer operations, 293 active landfill disposal sites and 146 recycling plants. All of those locations require the use of an enormous amount of land which explains why their principal property and equipment consists of land (primarily landfills and other disposal facilities, transfer stations and bases for collection operations), buildings, vehicles and equipment. WM has the largest truck fleet in the waste industry with some 26,000 collection and transfer vehicles (2018). WM leases property and equipment in the ordinary course of their business. The most significant of their lease obligations are for property and equipment specific to the waste disposal THE IMPACT OF ASU 2016-02 LEASES industry, including real property operated as a landfill or transfer station. The leases have varying terms of which some may include renewal or purchase options, restrictions, escalation clauses and other potential penalties which are used in determining minimal lease payments. The leases are classified as either capital or operating leases with the majority of them being operating leases with minimal lease terms much shorter than the asset’s useful life with the anticipation of lease renewal, replacement or that it will be replaced with fixed asset expenditures. Given the vast size of their network, and their heavy involvement in accounting for their plants and equipment for daily business operations this accounting standard update will have a major impact on the reporting of WM’s lease accounting of the organization in the representation of their lease obligations on the balance sheet. However it is not anticipated given the new standard will cause too much of a shakeup in their normal accounting operations. That is, due to the nature of their business they have already separated the accounting of their leases into three distinct classifications: operating, capital and landfill leases. According to the Notes to Consolidated Financial Statements it’s 2018 First Quarter Form 8-K, “the minimum contractual payments due for its’ operating lease obligations are $101 Million in 2018, $83 million in 2019, $72 million in 2020, $54 million in 2021, $31 million in 2022 and $248 million thereafter.” Assets under capital leases are amortized on a straight line basis either over the useful life or lease term of the asset. The present value of the current lease payments are recorded as a debt obligation. From an operations perspective landfills that Waste Management, Inc. lease are treated similar to ones that they own because they generally will operate the landfill for the life of the operating permit (WM 2018 Form 10-K). The most significant portion of their rental obligations for landfill leases is contingent upon operating factors such as disposal volumes and usually do not require contractual minimal rental THE IMPACT OF ASU 2016-02 LEASES obligations. The transition into accounting in accordance with ASU 2016-02 should be relatively seamless as it relates to accounting for leases, the noticeable changes will be in the financial statement representation. The changes in the financial ratios will generally occur primarily in assets and liabilities relations. Given WM’s high utilization of operating leases there will be an increase in interest bearing debt and EBITDA will most certainly increase as rent expense will be replaced with interest and amortization expense, which are below-the-line charges. However Return on Assets will according decrease. Although large in value, the net effects of the increase and decrease to these profitability ratios will be minor for valuation purposes. It is also likely that operating cash flow will increase because cash payments for leases will now be classified as financing activities rather than operating expenses in the Statement of Cash Flows. WM’s Current Ratio, which measures total liabilities over total shareholder’s equity will see a decrease in value as result of compliance to the new requirement. Conversely their Debt to Equity ratio will increase and the impact of the increase will be detailed on balance sheet rather than in the Notes to Consolidated Financial Statements which as the previous standard allowed for. Some of these changes might indicate higher operating and financial risks as well as tightened debt covenant restrictions are on the horizon for WM once the financial markets begin to reassess the appropriate risk level applicable to organizations who carry reasonably high lease obligations (WM 2018 Form 10-K). Investment bankers will need to reassess their lending risk levels associated with pertinent financial ratios used when assessing credit worthiness assessments. Many investors rely on the research of stock analysts, mutual fund managers and television analysts to get a feeling of whether or not to invest in a particular company. Those individuals utilize the previous ratios to quickly compare and contrast the performances of THE IMPACT OF ASU 2016-02 LEASES company’s within a given industry. Preparers and users of financial statements are certainly aware of the pending implementation of ASU 2016-02 and will anticipate seeing drastic changes to the balance sheet for WM in the coming quarters. WM has clear declaration of lease types in their financial statements, therefore the implementation of the new accounting practices will actually benefit the company in that it provides potential investors to now see what they have been closely segregating and monitoring directly displayed in the balance sheet and subsequent ratios. It is not anticipated that stock price or P/E ratio will be impacted by the new standard. These changes should not greatly impact the recommendations of stock analyst to investors given that there has been no change in the normal business practices nor a decrease or drop productivity caused by compliance to the new standard. The increases to EBITDA as well as other changes in the Income Statement and Statement of Cash Flows will be factored into analyst models to account for the fluctuations in the financial ratios traditionally used for valuations. According to their first quarter 2018 Form 10-Q, they have yet to implement as referenced in the Notes to Consolidated Financial Statements. In conclusion, ASU 2016-02 will bring clarity to previously distorted financial statements provided under the previous provisions for lease accounting. While increases and decreases to financial ratios will be evident upon simple comparison from previous financial statements, it will have minimal impact on the recommendations of analyst regarding stock purchases and overall company valuation. Depending on the size of the organization the costs incurred to implement the required accounting and system upgrades will vary as well as the potential impact this effort will have on the overall productiveness of all companies affected. THE IMPACT OF ASU 2016-02 LEASES References FASB ASU 2016-02 Leases 2018 Waste Management 10K Report FASB 2009 Discussion Paper, Leases: Preliminary Views FASB 2010 Exposure Draft, Lease (Topic 840) FASB 2013 Exposure Draft, Leases (Topic 842) Securities and Exchange Commission (SEC), 2005, Report and recommendations pursuant to Section 401(c) of the Sarbanes-Oxley Act of 2002 on arrangements with off-balance sheet implications, special purpose entities, and transparency of filings by issuers. Washington, D.C. CPA Journal PricewaterhouseCoopers (2009). The future of leasing: Research on impact of companies’ financial ratios. https://www.accountingweb.com/aa/standards/the-wait-is-over-fasb-issues-new-guidance-onlease-accounting (Jason Bramwell) Weidner, Donald J., New FASB Rules on Accounting for Leases: A Sarbanes-Oxley Promise Delivered (November 14, 2016). 72 Business Lawyer 367 (2017); FSU College of Law, Public Law Research Paper No. 816; FSU College of Law, Law, Business & Economics Paper No. 1614. Available at SSRN: https://ssrn.com/abstract=2847821