In a long-anticipated move that could make corporate balance sheets look a good deal fatter than they seem today, the Financial Accounting Standards Board on Thursday updated its lease accounting standard.
Under the new guidance, companies that lease property or equipment will be required to recognize on their balance sheets assets and liabilities for leases with terms of more than 12 months.
Like current Generally Accepted Accounting Principles (GAAP), how lease expenses and cash flows are reported will depend on the lease’s classification as a finance or operating lease. But unlike current GAAP, which requires only capital leases to be recognized on balance sheets, the updated standard will require both kinds of leases to be recognized on the balance sheet.
Public companies will have to start complying with the new standard for fiscal years and interim periods within them beginning after December 15, 2018. For all other entities, the leases update will take hold for fiscal years starting after December 15, 2019, and for interim periods within those years beginning after December 15, 2020. FASB will permit early application to report under the new rule.
The wide-scale recognition of leases on the balance sheets of companies under the new rule “will significantly increase their assets and liabilities, in some cases without any related change in their equity,” says Kimber Bascom, the global leasing standards leader at KPMG. “So basically, it makes the organization look bigger if they have a lot of leases.”
That might give investors the impression that the company is less efficient in its deployment of capital than they previously thought. “To the extent that investors may not have thought of leases as part of the population of the company’s assets and liabilties in the past, this now gives them a different perception about how lean an organization is in accomplishing its business objectives,” adds Bascom.
“CFOs will clearly want to be prepared to communicate with investors about their business and the nature of their leasing arrangements, and in all likelihood will want to make the case that even though the accounting has changed, the fundamentals of their business is the same,” he says. “That is often the case when there are accounting changes.”
From FASB’s perspective, the huge amount of lease assets and liabilities that were going unrecognized was “one of the last remaining holes in off-balance sheet accounting that needed to be filled,” FASB vice chair James Kroeker told CFO.
Based on 2014 public company filings done in XBRL format, FASB technicians found approximately “north of a trillion [dollars] in undiscounted lease obligations that are reported in the footnotes,” he said, noting that the board found “the economic size” of that number a “compelling” reason to add the transparency of bringing that amount back on the balance sheet.
Kroeker added that FASB found through its investor outreach efforts that credit rating agencies, along with many “industry focused analysts and … more sophisticated investor[s]” were already “estimating lease obligations and adding them, in their analysis, to entities’ balance sheets.”
“Of course, the standard doesn’t change [companies’] economic position in any way shape or form. All it does is add neutrality and comparability to those entities that choose to finance through leases to those who choose alternative means to finance capital,” he says.
“That doesn’t mean that finance professionals, the treasurers’ group, the controllers’ group, or the CFO aren’t going to get questions about the impact,” Kroeker adds. “This just puts investors on a more level playing field.”
The FASB vice chair contends that although bringing the accounting of operating leases onto the balance sheet represents a big change, the update does so in a way that eases the transition by enabling companies to use their existing processes and systems.
“We’ve done that by keeping the dividing line between capital and operating leases, leaving unchanged the accounting for operating leases in the income statement and the statement of cash flows,” he says.
In addition, FASB is “simply bringing onto the balance sheet the future unpaid lease obligations in an operating lease by recording an equal right-to-use asset and an obligation to pay for those leases,” according to Kroeker.
“It’s done in a way that doesn’t disrupt existing systems and processes,” he says, “and adds transparency to the previously unrecorded obligations of those leases.”
By contrast, in the International Accounting Standard Board’s own new leasing standard, issued on January 12, IASB classifies all leases as finance leases, thus removing its prior distinction between operating leases and finance leases.
Before the IASB and FASB decided to go their separate ways on lease accounting, they together proposed in a 2013 exposure draft to separate lease reporting into two classes, one operating and one finance. “One of the most vocal aspects of the feedback we got [to the exposure draft], particularly from the preparers, was that they did agree that there should be two classes of leases,” recalls Kroeker. “But they thought we should keep the dividing lines consistent with those of today in U.S. GAAP.”
In its outreach to corporate financial statement issuers, the board further asked: “If we were to move to this model and IASB didn’t, would you see this as being cost beneficial, or would you see it as being more beneficial for us to move to the [IASB] model?” he says.
“And the resounding feedback we heard about that was no” to converging with the single-class IASB model, Kroeker adds. U.S.-based multinationals preferred to keep separate sets of books for their reporting in U.S. GAAP and in International Financial Reporting Standards rather than to depart from GAAP and recognize all leases the same way, he suggests.