The Financial Accounting Standards Board (FASB) has decided to wrap up a decade of controversy with a new accounting standard on leases. If your company leases equipment or real estate, the new standard could significantly alter what’s reported on your balance sheet — which, in turn, could alarm unprepared lenders and investors.
A long and winding road
In 2005, the Securities and Exchange Commission (SEC) estimated that about $1.25 trillion in operating leases wasn’t being recognized on public company balance sheets. The SEC’s 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 concluded, “Many issuers see leasing as an attractive form of financing asset acquisition in part because leases can be structured so as to avoid recording debt.” In the wake of the Enron scandal involving off-balance sheet financing scams, the SEC urged the FASB to take action.
So, in 2006, the FASB added the project on accounting for leases to its agenda. But long before that, investors and analysts complained that existing lease accounting guidance offered companies too much leeway to structure leases to stay off their balance sheets.
Companies that don’t record their leases as liabilities look like they have healthier debt-to-equity ratios and more available funds than companies that finance new pieces of equipment or take out mortgages to build offices and stores. For some businesses, such as airlines that lease their fleets of planes or retail chains that rent all their storefronts, lease payments make up significant financial obligations.
Most critics said they wanted these costs to be more transparent, but there has been little to no consensus on the best way for the FASB to require this. In 2013, the FASB released Proposed Accounting Standards Update (ASU) No. 2013-270, Leases (Topic 842), which was largely aligned with the International Accounting Standards Board’s Exposure Draft (ED) No. 2013-6, Leases.
The boards didn’t see eye-to-eye on several issues, however, and now will publish separate final accounting standards. But, they agree on the key premise that almost all leases should be recorded on company balance sheets.
A significant change
Under the new standard, which is expected to be published in early 2016, businesses will record the effects of leasing storefronts, factory equipment, airplanes and other types of fixed assets as debt on their balance sheet. This ends a decades-old practice in U.S. Generally Accepted Accounting Principles (GAAP) of keeping lease costs off company balance sheets.
The board approved the standard with a 6-1 vote. FASB member Marc Siegel voted against it. “This is a really hard decision for me. On the pro side of what the standard is doing, I think obviously an amount [will be recorded] on the balance sheet,” Siegel said. “On the con side, while we will have an amount on the balance sheet, I think it’s going to be mismeasured.”
The rest of his FASB colleagues, however, said the forthcoming standard would benefit analysts and investors, even if it was not as broad of a change as the standard-setter once envisioned.
“This is not the standard I would have written; many of my concerns still exist,” FASB member Harold Schroeder said. “Is this an improvement to where we are today? I’ve come to the conclusion that yes, this is a notable improvement to where we are.”
Delayed effective date
The bad news is that this standard could result in loan covenant violations for some companies, because it could make them appear more leveraged. The silver lining? Companies will have several years to implement the change and be able to forewarn lenders and investors about how the change will affect key financial statement ratios.
For public companies, the standard is expected to go into effect for annual periods that begin after December 15, 2018. In other words, compliance would start in 2019 for calendar-year entities. Private companies would have an extra year to comply.
Sidebar: No consensus on global lease accounting standard
Differences in business practices between U.S. and overseas companies caused the project to produce a converged accounting standard on leases to fall apart. One of the key differences is the treatment of leases on companies’ income statements.
Under the Financial Accounting Standards Board’s (FASB’s) model, some leases are treated as purchases and considered financing arrangements with interest and amortization expenses built into the amount recorded on the income statement. Others are considered simple rentals with even payments over time. In contrast, the International Accounting Standards Board (IASB) treats all leases like financing arrangements.
The lack of consensus has proven too hard to bridge. U.S. accountants have been dividing leases into the two categories for decades and had no problems with it. In addition, they told the FASB the split-reporting works with the U.S. tax and regulatory regimes.
Conversely, accountants overseas felt the decision to divide leases into two categories was a complexity that should be eliminated from current financial reporting. Overseas businesses said accounting for low-value leases would be onerous under the proposed accounting overhaul. The IASB responded by carving out an exception for small-ticket leases, such as photocopiers, cash registers and office equipment. The FASB heard no such complaints and decided not to add an exception.
Although the FASB and IASB won’t publish identical standards, the central goal of the final standards will be the same: to improve transparency when reporting future lease obligations.