The Quiet Revolution of Lease Accounting An accounting change that brings lease obligations onto balance sheets represents one of the biggest restatements in recent financial history. But what happened to the “lease-pocalypse” some experts had been predicting?

Accounting standards authorities have long struggled with leases: Are they an essential aspect of corporate performance, or a marginal one? Should they be highly visible or can they be safely tucked away? Leases — a contract allowing the use of an asset, property or service for a fixed period of time in exchange for regular payments — are ubiquitous in corporate America. Accounting standards in recent decades treated them differently: Capital leases (also known as finance leases) were included on balance sheets and operating leases were left off, often reappearing, if at all, in obscure footnotes. Why the difference? In a capital lease, the asset may be transferred to the lessee at the end of the term, like a car that’s leased with the option to buy; in an operating lease, the owner retains control throughout — say, of an office building with multiple tenants or a data center with many customers.

Operating leases have become a common component of off-balance-sheet liabilities. Some sectors such as retail or casual dining and fast food with multiple outlets or airlines with fleets of leased aircraft carry large amounts of operating leases. In recent decades, off-balance-sheet liabilities in general have been blamed for a variety of financial woes and as a source of mismanagement at best, malfeasance at worst; the financial crisis of 2008–’09 and Enron Corp.’s 2001 collapse are examples of the former and the latter, respectively.

Critics argued that liabilities off the balance sheet reduce transparency and comparability for investors, and encourage suboptimal capital allocation and decision-making by management.1 The Financial Accounting Standards Board (FASB), the private, nonprofit organization that establishes rules for generally accepted accounting principles (GAAP) in the U.S., began to seriously discuss off-balance-sheet liabilities in 2006 and focused specifically on lease obligations — meaning operating leases. In the decade that followed, FASB engaged in research, debate, multiple exposure drafts, comment periods and educational sessions on new rules for lease accounting.2

 The goal of the new rules was straightforward. “It puts things in a more transparent condition,” FASB vice chairman James Kroeker told the Wall Street Journal in 2016, when the organization released a new standard on off-balance-sheet lease recognition for the first time. He noted that the rule “adds light to one of the last remaining crevasses of off-balance-sheet accounting.”3 As accounting firm Deloitte said in the run-up to the new standard, “We expect the standard will have far-reaching implications in areas such as accounting, finance and reporting, real estate, tax and technology, among others.”4 These changes were certain to affect not only directors, executives and workers but analysts, investors and the financial media — everyone trying to more precisely understand and value public corporations. The reforms should make the market more efficient.

The lobbying was intense to the point of hysteria. LeaseAccelerator, a firm that sells software for leasing, called the looming implementation of new leasing standards, “the lease-pocalypse.” A 2012 study by Chang & Adams Consulting predicted that the change would affect some $1.5 trillion in leases in the U.S., equal to the gross state product of 20 states, and destroy between 190,000 and 3.3 million jobs while slashing gross domestic product and household wealth.5 The study was commissioned by a group of real estate operators, homebuilders and the U.S. Chamber of Commerce. Others feared that credit rating agencies would downgrade ratings because of the increased debt load from operating leases.6 Still others worried about covenants and credit agreements running afoul of rising leverage ratios from the inclusion of operating leases.7

Nearly three years later, on January 1, 2019, FASB implemented the new accounting standards update (ASU). The long-awaited rule mandated that leases appear on balance sheets as debt at the present value of future debt payments. This affected a wide range of other financial metrics; implementation of the new standard amounted to the largest restatement of financial assets in recent history. Approximately $3 trillion in operating leases had to be accounted for, which meant that balance sheets across the investable U.S. market would expand by approximately 10 percent, in aggregate, with some companies seeing increases that were multiples of that.8

And yet, like the fears about Y2K at the turn of the century, the lease-pocalypse never arrived. For all the disruptive potential, implementation has proceeded relatively smoothly. This was helped by the long lead time and the decision to give smaller and private companies an extra year to comply. A number of companies, including Microsoft, made the changes before the 2019 implementation. Many others offered guidance about what the new balance sheets would look like. And it may also be attributable to the sophistication of financial, investment and corporate players. Accounting, after all, is just a tool companies use to report their status to stakeholders, particularly investors. It provides snapshots of organizations that are constantly evolving. The act of moving operating leases onto balance sheets does not alter company fundamentals. In many cases, these numbers had been available — as they were for credit rating agencies like Moody’s — if you knew where to look. In fact, many analysts and investors know exactly where to look.

Of course, there may be other explanations for the lack of major disruptions — not to say job losses and evaporating GDP. The year 2019 saw a remarkably bullish U.S. stock market, which may have cushioned some of the effect of these changes. Low interest rates take some of the sting from the appearance of greater leverage. As economic conditions change, the sensitivity toward debt and leverage may increase. Still, in hindsight, the accounting technocrats at FASB may well feel blessed that the agency chose a year like 2019 to implement these accounting changes.

The Long March to Leasing Standards

Change on leases has been a long time coming. The issue of how to account for operating leases was first addressed in the U.S. in 1949, when the Committee on Accounting Procedure determined that operating lease accounting should not be used for long-term leases — effectively endorsing off-balance-sheet financing for most leases. FASB crystallized the treatment of off-balance-sheet financing in 1976 with a policy statement, Financial Accounting Standards (FAS) No. 13, now known as Accounting Standards Codification Topic 840 (ASC 840). These standards became effective on January 1, 1977.9

Until the late 1990s, the growing practice of off-balance-sheet financing seemed to be relatively benign. At the turn of the century, however, Enron changed everything. The Houston-based natural-gas-producer-turned-energy-trader hid huge losses and fabricated earnings through a bewildering array of off-balance-sheet special-purpose entities, resulting in the bankruptcy of the corporation, the failure of its accounting firm and a raft of criminal charges and convictions for senior executives.

Enron and a handful of other corporate scandals provoked demands for increased transparency and an enhanced ability to compare companies, but the development of new accounting rules takes time. In 2006, just before the financial crisis, which featured its own off-balance-sheet disasters, FASB and International Financial Reporting Standards (IFRS) began work on new rules to bring operating leases onto balance sheets. In 2011, Barron’s wrote that “accounting for leases has become a hot topic in finance departments of major U.S. corporations, and could become one for Wall Street as well.”10 The topic was so hot that Barron’s never returned to it. In fact, although the magazine predicted that the new rules might be out by 2013, it took until 2016 to publish ASC 84211 and IFRS 16, and implementation of the standards under GAAP and IFRS did not begin until 2019.

All that’s not to say that implementation was not a challenge, particularly since FASB also asked financial institutions to adopt new standards for recognizing credit losses, hedging and long-duration insurance contracts in the same time period.12 The details of the lease standard are highly technical, and companies and their accountants struggled with delays and software snafus. Several years ago, accounting firm PwC noted that lease information was highly decentralized at 39 percent of the companies it surveyed.13 Most respondents said data collection, not accounting or tax issues, would be the greatest challenge. A survey by Deloitte early last year found that despite the long run-up, only 30 percent of private companies planned to implement the standard on schedule, while 33 percent admitted they were unprepared to comply and 44 percent said they were “somewhat” prepared.14 As a result, FASB voted unanimously in mid-July to push back the implementation date for small companies, private companies, small banks and insurers for a year, until January 2021. (FASB often gives smaller and private institutions, which have fewer resources, more time to implement major changes.)

In many cases, these numbers had been available — as they were for credit rating agencies like Moody's — if you knew where to look.

Despite the broad common interests of regulatory agencies around the world and the initial intent to hammer out a uniform global rule, U.S. GAAP and the IFRS lease standards have significant differences. Some of these reflect practices and challenges that vary by region. A 2016 study by IFRS revealed that while 62 percent of companies in North America disclose off-balance-sheet leases, only 47 percent of European companies, 43 percent of Asian businesses and 23 percent of Latin American and African companies do so.15

Although balance sheet comparability for some metrics appears to be converging for GAAP and IFRS, income and cash flow statements are diverging. And while transparency across all companies has improved, transparency across regions remains elusive. GAAP, for instance, retains operating leases and therefore rent expenses on profit-and-loss and cash flow statements. However, under IFRS, which applies to companies in 140 countries, leases are recorded as amortization and interest expenses. This creates a front-end-loaded expense trajectory, in contrast to straight-line expensing under GAAP.

The New Look of Leases and Balance Sheets

Every company that choses to lease rather than buy will see its balance sheet expand because of the need to account for operating leases. Under the new standard, companies book operating and finance leases over a month in length as liabilities, based on the net present value of lease payments and financing, and as an addition to assets. This reflects their ability to use the lease, whether it’s on a factory, office building or a fleet of airplanes.

A November 2018 McKinsey & Co. study highlighted three industries (out of 21) that will experience the biggest change: Broad retailing has seen debt rise by an average of 64 percent, with food and staples retailing and transportation growing by 55 percent and 40.3 percent, respectively.16 Industries including energy, pharmaceuticals and biotechnology, semiconductors and equipment, food, beverage, tobacco and utilities have seen increases of around 5 percent.

A July 2018 study by LeaseAccelerator ranked the top 1,000 U.S. companies by their operating lease liabilities, using data on operating leases found in the footnotes of the companies’ financial statements.17 Not surprisingly, the study found that certain industries would have a greater exposure to the change: airlines, which lease not only planes but terminal space, gates and baggage handling areas; real estate investment trusts; food services; general merchandise; and apparel retailers with extensive stores and warehouses.

A major accounting shift may have very different effects on investors with varied goals, sensitivities and skills. As LeaseAccelerator dryly notes: “Most sophisticated institutional investors have studied these off-balance-sheet leases and factored them into their financial models. However, there is ongoing concern that smaller, individual investors might not be considering these additional leasing obligations when making decisions about which stocks or bonds to purchase for their retirement fund or college savings.” Reported total assets and liabilities of portfolio companies will rise, and in some cases balloon, compared with previous accounting periods. As a result, many metrics investors use to evaluate risk, efficiency, financial health, valuation and other aspects of corporate operations will change. In July 2019, Credit Suisse warned that — given the sheer magnitude of the impact — misleading data feeds, inconsistent financial reporting and other discrepancies “could confuse and misinform investors.”18 Because accounting statements are so essential in analyzing companies, these changes may tell a very different story, even though underlying fundamentals and operations have not changed at all.

Navigating the New Standard

Many of the most important risk models employed in money management, including MSCI’s widely used Barra Risk Factor models, provide information to investors on the embedded factor exposures in their investment portfolios. Factors quantify exposures that are not idiosyncratic to the individual stocks in the investment portfolio. Examples of this include momentum, volatility, quality and size. All factor exposures are derived from financial ratios, and quality exposure is materially affected by the new standard, as debt to equity is one of the underlying ratios.

Outside of portfolio construction and risk management, the new standard makes traditional investment analysis more challenging. Companies are not required to restate their historical financial statements for the new accounting changes, so it will be difficult in some cases to compare the balance sheet items before and after the accounting rule change.

Moody’s Investors Service, for instance, announced in August 2018 that although it had long brought operating lease obligations onto its balance sheets when evaluating a company, it would in the future use company estimates, which it said would be more accurate.19 As for problems with covenants and credit agreements, many companies, at the urging of their accountants, may have amended those agreements based on the new standard. As it turns out, many credit agreements had existing provisions that said operating leases should not be treated as debt, no matter where they appeared.20

Moreover, although companies are not required to historically restate their financials, they must release the same footnotes; this allows investors to compare past statements with current disclosures and results. Specifically, the “Commitments and Contingencies” footnotes outline companies’ capital lease obligations due in tranches over the next five years and the cumulative obligations thereafter. Investors can use this information and apply a discount rate for the company to derive a net present value of operating lease obligations and create adjusted asset and liability values. While the analysis is not perfectly comparable, it should be close enough to create like-to-like comparisons of new and old data.

C-suite executives will have more urgent and increased transparency around financial metrics that more accurately reflect the fundamental performance and health of their businesses. Management teams’ compensation packages are heavily reliant on hitting milestones associated with their financial statements, such as earnings or cash flow growth and specific share prices.

Conclusion

FASB’s accounting standard change on leases takes further steps to increase transparency for investors and corporate managers. It represents a significant advance in improving the comparability of companies with similar structures that choose to fund their businesses in different ways. It may also improve corporate governance and hold management teams more accountable for the obligations they underwrite to fund their companies.

In retrospect, the rollout of the new standard may well be viewed, for all the fears and delays, as a model. From FASB’s perspective, part of that success was that it did not provoke major headlines; it did not roil markets. Instead, helped by a beneficent economic climate and rising markets, the implementation process appeared to suggest that companies and investors were both sophisticated and relatively well prepared for the change. Was there a lease-pocalypse? Not really. But it may well be, again like Y2K, that we avoided massive disruption by its very possibility.

 

Jeffrey Messina is a Managing Director at WorldQuant and has a BA in economics (with a concentration in financial markets) from Colby College.

B. Korcan Ak is a Vice President at WorldQuant and has a Ph.D. in business administration from Haas School of Business, University of California, Berkeley.

 

 

ENDNOTES

1. Kimberly Rodgers Cornaggia, Tim Simin and Laurel Franzen. “Manipulating the Balance Sheet? Implications of Off-Balance-Sheet Financing.” SSRN Electronic Journal (January 2011).

2. Financial Accounting Standards Board.

3. Michael Rapoport. “New Rule to Shift Leases Onto Corporate Balance Sheets.” Wall Street Journal (February 25, 2016).

4. “Operationalizing the New Lease Standard.” Deloitte (2019).

5. “The Economic Impact of the Current IASB and FASB Exposure Draft on Leases.” Chang & Adams Consulting (February 2012).

6. Brett Cotton, Douglas K. Schneider and Mark G. McCarthy. “Capitalisation of Operating Leases and Credit Ratings.” Journal of Applied Research in Accounting and Finance, Vol. 8, No. 1 (2013).

7. Charlie Shannon, “How Will the New Lease Accounting Standard Impact Loan Covenants?” Moss Adams (September 2016).

8. Yun Li. “A Big Change in Accounting Will Put $3 Trillion in Liabilities on Corporate Balance Sheets.” CNBC.com (February 16, 2019).

9. “FASB Issues New Guidance on Lease Accounting.” Financial Accounting Standards Board (February 25, 2016).

10. Jacqueline Doherty. “Out of the Footnotes, Into the Spotlight.” Barron’s (June 4, 2011).

11. “Accounting Standards Update, Leases (Topic 842).” Financial Accounting Standards Board (July 2018).

12. Ken Tysiac. “FASB to Propose Delaying Effective Dates for 4 Major Standards.” Journal of Accountancy (July 17, 2019).

13. “Impacts of the New Leasing Standard — Beyond Accounting: Consider These Top Systems, Data, and Process Challenges — and Potential Solutions.” PwC.

14. Vincent Ryan. “FASB Gives Private Companies Breathing Room on Lease Accounting.” CFO.com (July 17, 2019).

15. “IFRS 16 (Leases).” International Accounting Standards Board (January 2016).

16. Prateek Gakhar, Jyotsna Goel and Werner Rehm. “A Welcome Change in Lease-Accounting Rules.” McKinsey & Co. (November 2018).

17. “Who Is Most Impacted by the New Lease Accounting Standards?” LeaseAccelerator (July 2018).

18. Mark Maurer. “New Lease Accounting Standard May Mislead Investors, Credit Suisse Says.” Wall Street Journal (July 10, 2019).

19. “Moody’s Changes Its Treatment of Leases in Response to IASB and FASB Accounting Requirements.” Moody’s Investors Service (August 9, 2018).

20. Adam C. Wolk, David K. Duffee and Zack Polidoro. “Operating Leases and Credit Agreements in the US: What You Need to Know Before January 1.” Mondaq (August 20, 2018).

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