A Brief History of Lease Accounting
From Enron to FASB’s ASU 2016-02
Remember Enron and WorldCom? After those scandals, the U.S. Congress, the SEC, and FASB introduced numerous regulations to cut down on fraud and provide investors with greater transparency into higher quality financial reports. Congress rolled out the Sarbanes-Oxley (SOX) Act to protect investors from corporate fraud.
The Current Standards
One of the accounting loopholes the SEC identified was off-balance sheet operating leases. Under the current ASC 840 standard, leases are classified as capital leases or operating leases. Capital leases are reported on the balance sheet. Operating leases are disclosed in the footnotes of your financial statements as “off-balance sheet” operating expenses and excluded from important financial ratios, such as return on assets, that investors use to judge a company’s performance.
Image Source: IFRS Website
The different accounting treatment for operating leases makes it challenging for investors to gain an accurate understanding of a company’s real indebtedness. Professional investors and Wall Street analysts with years of expertise are able to make estimates, although they sometimes overestimate the liabilities arising from those obligations.
However, the average Main Street investor cannot easily get the complete picture. The SEC determined the confusion was a big problem. They asked the Financial Accounting Standards Board (FASB), which creates the standards for U.S. General Accepted Accounting Principles (GAAP), to work with the International Accounting Standards Board (IASB), which creates standards for the rest of the world, on a new, global standard.
The New Standards
FASB and IASB received comments from lessees, lessors, investors, and the general accounting community on one discussion paper and two exposure drafts. In February 2016, they finalized ASC 842 and IFRS 16. While the boards didn’t converge on a single lease accounting standard, both of the new standards still bring a much higher level of transparency to leases. Now, companies must capitalize all leases longer than 12 months on their balance sheets as assets and liabilities.
Leasing is just one of many areas to be overhauled by accounting boards over the past decade. The boards have also introduced major accounting policy changes for stock options, revenue recognition, corporate pension, and mergers and acquisitions. The goal of all of these accounting changes is the same as the lease accounting standards – to provide more transparency into financial reports of public companies – a benefit to shareholders.
The history of these lease accounting standards goes back even further than the past decade. For a complete guide to ASC 842, read the timeline below. For an IFRS 16 timeline, click here.
Timeline: The History of Lease Accounting (ASC 842)
The Committee on Accounting Procedure determined that operating lease accounting shouldn’t be used for long term leases. They issued the bulletin, Disclosure of Long-Term Leases in Financial Statements of Lessors, which required finance leases to be recorded as a leased asset and long-term liability. However, since capitalization was not required by GAAP, most lessees still used off-balance lease reporting.
The Accounting Principles Board issued Reporting of Leases in Financial Statements of Lessees which established that leases should be categorized as finance if the contract has a nominal purchase option.
The Accounting Principles Board issued Accounting for Leases in Financial Statements of Lessors which issued different criteria for finance lease identification than the 1964 opinion.
The SEC asked the FASB to create comprehensive lease accounting rules. They issued FAS 13, Accounting for Leases. This standard has been in place since 1976, though it has been amended multiple times since then.
The Enron Scandal took place causing the SEC to investigate accounting practices that could allow corporate fraud. At this point, the SEC discovered the off-balance sheet operating lease loophole.
The FASB and IASB issued an Exposure Draft and distributed it for public comments. The model set forth in the ED proposed that lessees move all leases onto the balance sheet as a right-of-use asset and liability. Lessees, lessors, and the accounting community in general reacted negatively to the ED because they felt the proposal was overly complex and lacked consistency.
After multiple discussions, meetings, and revisions, The FASB and IASB issued a Revised Exposure Draft, and opened a four month comment period. After, the boards solidified parts of the standard, including that all leases would be brought onto the balance sheet (except short-term leases), expense recognition models, and liability measurement.
The FASB issued an update to ASC 842 to both clarify and simplify the application of the new lease standard to land easements. The FASB also issued a proposal to ease companies’ transition to the new standard by offering a practical expedient that would allow companies to apply the transition provisions at the adoption date, instead of at the earliest comparative period. The proposal was approved in July of 2018. Also in July, the FASB issued codification improvements affecting narrow aspects of the standard.