FASB releases new lease accounting standard

The Financial Accounting Standards Board (FASB) has issued its long-awaited lease accounting standard, which will require that companies recognize their leases on their balance sheets.

The update, intended to improve financial reporting about leasing transactions, affects all public and private companies that lease assets such as real estate, airplanes and manufacturing equipment.

Firms have long been able to exclude most leases from their balance sheets, which may have made it difficult for investors looking at a company’s financial statements to calculate the true financial obligations of the firm. The new rule aims to give prospective investors a more accurate picture of a company’s health.

In part due to the collapse of Enron in 2001, the US Securities and Exchange Commission (SEC) issued a report on off-balance sheet activities in 2005 that recommended that changes be made to the existing lease accounting requirements to ensure greater transparency in financial reporting.

“The new guidance responds to requests from investors and other financial statement users for a more faithful representation of an organization’s leasing activities,” said FASB chair Russell Golden in a statement. “It ends what the [SEC] and other stakeholders have identified as one of the largest forms of off-balance sheet accounting, while requiring more disclosures related to leasing transactions.”

Under the new guidance, a lessee will be required to recognize assets and liabilities for leases with lease terms of more than 12 months.

The new standard also will require disclosures to help investors and other financial statement users better understand the amount, timing and uncertainty of cash flows arising from leases. These disclosures include qualitative and quantitative requirements, providing additional information about the amounts recorded in the financial statements.

The new standard will affect accounting at the management company level for all private equity firms with leases on items like office space or private planes. The standard will also change how portfolio companies report to their private equity backers, and will have an impact on debt to equity ratios, noted David Larsen of Duff & Phelps in a call with pfm.

From a valuation standpoint, the update may also change how private equity firms look to value their companies, and will be an important consideration when thinking about comparability with other companies. 

The accounting for private equity real estate firms that own the properties being leased – also known as lessor accounting – will remain largely unchanged from current US GAAP. However, the new standard contains some targeted improvements to align lessor accounting with the lessee accounting model, and with updated revenue recognition guidance issued in 2014, according to FASB.

For public companies, the new standards go into effect in 2019. For private firms, the standard is effective 2020.