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Lease Accounting Presents $2 Trillion Dilemma

Lease Accounting Presents $2 Trillion Dilemma

It’s #accountingweek here at Intelligize, which means we’re going to discuss subjects that sound boring but are sneakily important to issuers and their investors. Take, for instance, lease accounting standards. As far as Wall Street fodder goes, they may not be as entertaining as Elon Musk’s race to build a miniature submarine in time to save a Thai soccer team stranded in a cave, or his bizarre attack on one of the rescuers. But even the 3.5 percent fall in Tesla stock that followed his outburst, which cut $2 billion from Tesla’s market cap, is nothing compared to the fallout that is sure to accompany the changes to lease accounting standards that are set to go into effect next year.

That’s because virtually every public company–or, well, virtually every company period–leases either equipment or real estate. Under current accounting standards, issuers have been able to keep leases off their balance sheets. Naturally, this has proven frustrating to investors or anyone else trying to get an accurate picture of a company from its financial statement. Eventually, their complaints won over the Financial Standards Accounting Board (FASB), which together with the International Accounting Standards Board (IASB), revamped their rules on lease accounting.

One massive change lies at the heart of the new standards, which were unveiled in February 2016 and are poised to go into effect at the end of 2018. The change is this: corporate lessees now “should recognize the assets and liabilities that arise from [their] leases.” In other words, lessees have to include their leases on their balance sheets. (Lessors are affected to a much smaller degree; as FASB’s update on Topic 842 explains, the board “decided to not fundamentally change lessor accounting.”)

But for lessees, this is a $2 trillion issue. That’s the value of leases that will be moving onto corporate balance sheets as a result of the change. It’s going to hit some companies harder than others, particularly retailers, drug stores, restaurants, supermarkets, airlines, and telecommunications companies. Issuers in those industries and beyond should be bracing for impact now, and getting a strategy in place.

For companies looking for a way out, the standards don’t leave much in the way of loopholes. Indeed, it appears that the only way to keep a contractual arrangement off the balance sheet is if it does not qualify as a “lease” in the first place. On that front, the new standard does contract the definition of a lease somewhat. Under the updated guidance, if the lessee does not have the right to control the use of an asset, the arrangement isn’t a lease. (Previously, you could have a lease without control–at least where the lessee received all of the output from the asset in question.)

But nobody should be fooling themselves: this is a sea change, and when balance sheets start conforming with it, public perception of many public companies could change as well. All this change is coming soon: the rule takes effect in fiscal years beginning after December 15, 2018, meaning that if a company’s FY ends on December 13, they will have to be compliant with the new standard as of January 1, 2019.

For companies tasked with following them, there will be short-term pain in getting up to speed–and perhaps explaining their new results to shareholders. But for executives and shareholders, these changes seem to be a clear win that will offer greater transparency and accuracy in assessing the financial performance of companies subject to them.

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