In February 2016 the Financial Accounting Standards Board (FASB) released the new standard, ASU 2016-02 Leases (Topic 842). Soon healthcare entities will have to recognize all leases, with a term of greater than twelve months, on the balance sheet.  The new standard becomes effective for public companies in fiscal years commencing after December 15, 2018 and after December 15, 2019 for private companies.

Currently operating leases are included in the footnotes of the financial statements and not reported on the organizations’ balance sheet. Under the new standard, there will continue to be two types of leases, operating and finance leases. For both type of leases, the entity will recognize an asset and liability on the balance sheet – the asset representing its right of use and the liability representing the obligation to make lease payments.  The major change is that operating leases will now be reported on the balance sheet.

The recognition, measurement, and presentation of expenses will depend on the whether the lease is classified as finance or operating.  Finance leases will be expensed more quickly, with the expense front loaded similar to the current accounting for capital leases. Operating leases will continue to use the straight-line method for determining the monthly lease expense.  Due to the difference in the method of recognizing the expenses, the finance lease liability will decline more slowly than the right of use asset that will decline in equal amounts.  Classification as either operating or finance leases will be similar to the current criteria.

More contractual arrangements will be accounted for as leases, even without the word lease in their titles, as certain agreements may contain an embedded lease.  When the customer controls the use of the asset and the asset is explicitly or implicitly identified, the asset needs special attention as a portion or the entire contract could potentially be capitalized as a lease. Review of clinical or diagnostic equipment leases based on consumption or usage is encouraged.

The new standard will put added pressure on operating margins but will have no change in cash flow.  The first year expense for medical equipment could increase significantly under this standard.

Even with the effective date being years away, it is important to begin taking inventory and evaluating your current leases and contracts that may now be classified as a finance lease.  Financial analysis, including the impact to debt covenants and operating margin, and operational analysis including lease versus buying decisions and shorter lease terms should be completed.