On December 2, 2001, Enron declared bankruptcy — the largest bankruptcy in history at the time. The $63.4 billion Fortune 500 energy trading company had been using questionable accounting practices, hiding bad debt obligations and losses in off-balance sheet transactions for years. The scandal also brought down Enron’s auditing firm, Arthur Andersen (one of the world’s largest accounting firms), for its negligence in overseeing the company’s financial misdeeds. Financial experts and lawmakers at the time agreed that something needed to be done to prevent this from happening again: the standards for corporate accounting needed to change in order to provide greater transparency to investors. The resulting rules, ASC 842 and IFRS 16, which are herein explained, change how leases are accounted for.
Who Makes the Rules for Accounting? FASB and IASB
In the United States, the set of guidelines ensuring uniformity for accounting and financial reporting is established by the Financial Accounting Standards Board (FASB). FASB is an independent nonprofit organization that establishes Generally Accepted Accounting Principles (GAAP), which are embodied in FASB’s Accounting Standards Codification (ASC). FASB is comprised of accounting and economic experts recognized by the Securities Exchange Commission (SEC) as the authority for all corporate accounting practices, and FASB’s rules are also recognized by the Board of Accountancy and the American Institute of CPAs (AICPA). The nonprofit organization works closely with the Governmental Accounting Standards Board (GASB), which makes accounting standards for state and local governments.
The international counterpart to FASB is the International Accounting Standards Board (IASB), which establishes accounting standards globally. FASB and IASB seek to work together to standardize accounting rules so business conducted internationally more uniformly complies with accounting standards elsewhere, regardless of location. IASB has its own set of rules, the International Financial Reporting Standards (IFRS).
Why Were the Rules Changed?
It was abundantly clear to FASB and IASB that accounting loopholes enabled Enron to commit conspiracy and fraud. This needed to be prevented in order to properly assess a firm’s worth. After publishing several exposure drafts that included proposed changes about how the accounting for leases would be treated, FASB released ASC 842 in February 2016. The IASB released their own standard, IFRS 16 in January 2016. ASC 842 called for compliance for both public and privately held companies beginning December 2019. FASB decided in July 2019 to postpone compliance to December 2020 for private companies and non-profit organizations because it was determined that many firms lack proper resources and are simply not prepared for these changes.
What Do the Rules Mean for Your Business?
ASC 842 states that lessees (those who hold the lease; in real estate, the “tenant”) must review all corporate leases, including those for commercial real estate, and determine whether each lease obligation is classified as a “finance lease” (or “capital lease”) or an “operating lease” (or “service lease”) under the new accounting standards. Finance leases are contracts longer than 12 months that grant the lessee control of specified property (i.e. office space) for a set period of time. Importantly, finance leases must be identified as assets (as opposed to operating expenses) on a company’s balance sheet as if the leased property was owned by the company. Service leases, however, remain factored as operating expenses (as opposed to assets) and are therefore not included on a company’s balance sheet. Service leases are instead listed as an expense item on the company’s income statement.
As an example, let’s say you are leasing an office space. Whereas you formerly expensed your office rental costs as an operating expense, you may now need to identify your lease as an asset on your balance sheet (a finance lease). These adjustments might have an impact on your company’s ability to borrow money, account for net income, correctly file tax returns, and more. Perhaps you should consider purchasing an office building or that distribution center you’ve been leasing? The FASB and IASB standards require businesses to get educated quickly in order to remain both compliant and competitive.
Who Has to Comply?
While all public and non-profit organizations are subject to GAAP accounting standards, in reality, these accounting changes impact everybody, since privately held companies are typically forced to comply with GAAP measures when submitting audited financials to landlords, satisfying lender requirements, raising capital and more. For many companies, compliance will be time-consuming and expensive, which is why all companies should be preparing for these changes by better understanding their lease terms and conditions. It’s imperative that if you are not familiar with how these accounting changes might impact your business, you seek advice from qualified accounting professionals.
Where Can I get More information?
If you want to do a deep dive into the rules, here are a few resources:
- Deloitte: ASC 842 - Leases and IFRS 16 - Leases
- Grant Thornton: Helps Navigate FASB Leasing Guidance and Insights into IFRS 16
- KPMG: Leases and ASC 842 and Handbook Ernst & Young: Lease accounting - Accounting Standards Codification 842, Leases and IFRS (International Financial Reporting Standards)
- PwC: Leases and ASC 842 and IFRS - In Depth
Tom is the Regional Senior Vice President for Truss, officed in Washington D.C. He has been a broker for 10 years and enjoys helping tenants find spaces that align with their business strategies. You can reach him at firstname.lastname@example.org