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.

James Kroeker

James Kroeker James Kroeker

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.

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4 responses to “New FASB Lease Standard Could Inflate Balance Sheets”

  1. Ok, so the day before the new standard goes into effect, a business generates some amount of annual free cash flow. The day after the new standard that same business is still generating the same amount of annual free cash flow, but somehow investors are better off knowing some grossed up numbers on a company’s balance sheet that no one other than a bunch of technical accounting types understand how to calculate and those investors are now much better equipped to evaluate the performance of the company? Ok, I think I’ve got it.

    Here’s a prediction, more interested parties than not will be adjusting to remove the impact of this standard in evaluating a business than are now currently calculating “right to use” assets and corresponding liabilities and adding them to a company’s balance sheet.

    Just one lowly CPA’s opinion.

    • Disagree, Benjamin. For too long organizations were using leases to hide spending, especially in hospitals for large pieces of equipment. While free cash flow will be the same, the disclosure has been brought to the financial statements. I do realize that the leases were disclosed in the footnotes, where a fraction of a % of investors and others actually spend some time. I am not looking at this from a CPA standpoint, but from an investor and businessperson, so I understand your position. I will say hats off to FASB for not relenting to the silly ISAB’s regulations. A leased facility is not a financial assets and should not be treated as such.

      • Come on BA! Having a grossed up balance sheet to look at is not going to help you understand where a business does or doesn’t spend its cash. If anything, investors will now have to spend more time digging through the notes not less in order to understand what level of future cash outlays will be required under existing lease agreements. If they weren’t reading the notes before, why would they now? Is it because we are telling them the information is now more accurate from a purist-sense? Trust me, BA, I am on your side on this, but be careful what you wish for!

  2. I can’t help but wonder what this is going to do to the leasing industry.
    With Leases now on the balance sheet, everyone will see the premium a company pays to a Landlord who by definition has to charge more than the bank. With these assets now on the balance sheet companies might as well own the asset and have the benefits of ownership.
    In the long run this is likely to impact many landlords but in the short-term there should be an immediate impact on the data center collocation industry as well as technology leases.
    Any opinions?

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