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, and FASB introduced numerous regulations to cut down of 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 previous standards

One of the accounting loopholes the SEC identified was off-balance sheet operating leases. Under the ASC 840 standard, leases were classified as capital leases or operating leases. Capital leases were reported on the balance sheet. Operating leases were 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 asc
 

The different accounting treatment for operating leases made 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 made estimates, although they sometimes overestimated the liabilities arising from those obligations.

However, the average Main Street investor couldn’t 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.

ASC 842

Lease Accounting Handbook

The current lease accounting 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 these 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 Group of Four Plus One (G4 + 1) which includes Australia, Canada, New Zealand, the
    United Kingdom, and the United States plus the IASB published a discussion paper for a
    converged standard for lessees which called for the elimination of operating leases.

  • G4 + 1 began work on a converged standard for lessors building on the 1996 discussion
    paper.

  • 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.

  • FASB began work on a new lease accounting standard intended to close the loophole of
    off-balance operating leases.

  • The FASB and IASB issued a Discussion Paper proposing that lessees capitalize all leases
    on the balance sheet.

  • 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 published ASC-842, the new lease accounting standard for companies reporting
    under US GAAP. The IASB issued IFRS 16 (elFRS login required), the new lease
    accounting standard for companies reporting under the International Financial Reporting
    Standards.

  • 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.

  • The FASB issued codification improvements to ASC 842 in March that covered fair value,
    statements of cash flows, and transition disclosures.

  • Due to COVID-19 market disruptions, the FASB modified compliance deadlines for private
    and select not-for-profit organizations, pushing them out by one year. The earliest
    deadline is for those whose year-end is December 31 - they will need to transition to the
    standard by January 1, 2022.