By Phil Antico, CPA, Senior Manager – WithumSmith+Brown, PC
On November 8, 2016 the Securities and Exchange Commission (“SEC”) Division of Trading and Markets issued a no-action letter regarding the treatment of operating leases under the Securities and Exchange Act Rule 15c3-1. This letter is in response to a letter written by the Securities Industry and Financial Markets Association (“SIFMA”) to the SEC to express concerns with respect to the Financial Accounting Standards Board’s publication of Accounting Standards Update No. 2016-02 (Topic 842) issued on February 25, 2016.
Under the new accounting standard, lessees will be required to recognize operating leases (ie. leases for office space) on their statement of financial condition. For an operating lease with a term of greater than twelve months, lessees will recognize a lease liability, measured at the present value of lease payments and a corresponding “right-of-use asset” representing their ability to use the leased property. For broker-dealers, the effective date for the standard is for fiscal years beginning after December 15, 2018. This new lease standard, absent of this no-action letter, would have had a material effect on the net capital of all broker-dealers that have operating leases greater than twelve months. The result would have been a non-allowable asset with the corresponding liability contributing to aggregate indebtedness as well as the deterioration of the aggregate indebtedness to net capital ratio. This would have required owners of broker-dealers to make additional capital infusions into the entity prior to this accounting rule taking effect or risk a potential net capital deficiency.
The no-action letter states the SEC Division of Trading and Markets would “not recommend enforcement action if a broker-dealer computing net capital adds back an operating lease asset to the extent of the associated operating lease liability. If the value of the operating lease liability exceeds the value of the associated operating lease asset, the amount by which the liability’s value exceeds the associated lease asset must be deducted for net capital purposes. A broker-dealer cannot add back an operating lease asset to offset an operating lease liability unless the asset and the liability arise from the same operating lease; nor can a broker-dealer add back combined or aggregated operating lease assets to offset combined or aggregated operating lease liabilities.”
With respect to how the no-action letter gives relief to the aggregated indebtedness calculation and ratio the SEC Division of Trading and Markets would “not recommend enforcement action if a broker-dealer determining its minimum net capital requirement using the AI standard does not include in its aggregate indebtedness an operating lease liability to the extent of the associated operating lease asset. If the value of the operating lase liability exceeds the associated operating lease asset, the amount by which the lease liability exceeds the lease asset must be included in the broker-dealer’s aggregate indebtedness. A broker-dealer cannot add back an operating lease asset to offset and operating lease liability unless the asset and the liability arise from the same operating lease; nor can a broker-dealer add back combined or aggregated operating lease assets to offset combined or aggregated operating lease liabilities.”
In each case, broker-dealers will need to analyze each lease individually to determine the net capital effects. This no-action letter eases the concerns of the broker-dealer community as the new lease accounting standard was going to have unintended consequences in the broker-dealer industry. Contact your Withum team for additional information. Please see below for a link to the no-action letter.