History of Lease Accounting – Why Were the New Standards Introduced?

By October 15, 2015Blog

A Brief History of Lease Accounting

From Enron to FASB’s ASU 2016-02

Remember Enron and WorldCom? After they crashed, the SEC investigated off-balance sheet transactions and discovered a loophole: operating leases. Today, 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.

Balance Sheet Changes with New Lease Accounting Rules

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 confusion, the SEC determined, was a big problem.  Thus, the SEC asked the Financial Accounting Standards Board (FASB), which creates the standards for U.S. Generally 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, converged standard.

Over the past 15 years, the main actions of the U.S. Congress, the SEC, and FASB have introduced numerous regulations to provide investors with greater accuracy of and transparency into the financial reports of public companies. In the wake of the accounting scandals of Enron, WorldCom, and HealthSouth between 2001 and 2003, Congress rolled out Sarbanes-Oxley (SOX). The goal of SOX was to protect investors from corporate fraud. In this same vein, the new lease accounting standards bring a much higher level of transparency to leases. All leases longer than 12 months must be capitalized and reported on a company’s balance sheet as assets and liabilities.

Leasing is just one of many areas to be overhauled by accounting boards over the past decade. Major accounting policy changes for stock options, revenue recognition, corporate pension, and mergers and acquisitions have been introduced over the past 10 years. The goal of these accounting changes is to provide more transparency into and consistency for the financial reports of public companies – a benefit to shareholders.