Why Do We Need a New Lease Standard?

            We are frequently asked why we need a new FASB lease standard. Critics of the new proposed standard complain that the benefits are offset by the costs to implement, maintain, and adjust company balance sheets to reflect the added debt. Let’s recall that the new FASB (and IASB) proposed standard requires placing all leases on the balance sheet as assets, and corresponding liabilities. There are slight differences between the International Standard, and the US FASB version primarily dealing with a distinction in capital leases (Type A) and operating leases (Type B) The International standard requires that all leases be classified as Type A, whereas the US version classifies all non-capital leases as operating leases (Type B) with straight line amortization of the rent.

            Small businesses as communicated by one of their industry groups, takes strong exception to the burdens and costs of adopting the new standards. In 2012, two congressmen sent a letter on behalf of 58 other Congressional members urging FASB to reconsider the proposed standard, as being a heavy burden to small business, and a “job killer.” Congressmen Peter King and Brad Sherman reiterated their concerns in an article published in November, 2014 raising the specter of job loss of 190,000 individuals and an economic hit of $400 million per year indefinitely.

            So do we need these new standards? Before we answer this question let’s review the consequences of less than transparent financial reporting over the last decade. Remember Enron? Enron’s use of fraudulent accounting gimmicks and off balance treatment of debt led to one of the largest bankruptcies in US history. By reporting inflated revenues,  “mark-to-market” valuation of assets, and the use of exotic use of SPEs (special purpose entities) to hide debt, Enron collapsed in 2001, along with their accounting firm, Arthur Anderson.  Their chief operating officer, Jeffrey Skilling, and Chief Financial Officer, Andrew Fastow, were convicted of securities fraud with long jail sentences. The CEO, Kenneth Lay, died during his trial.

            But there’re  more recent examples. How about the financial crisis of 2007-2008? This disaster can be traced to less than transparent reporting of enormous debt as a consequence of using exotic financial tools as Credit Default Swaps, Collaterized Debt Obligations, and the failure of credit rating agencies to accurately analyze and report the effects of these tools on corporate debt and risk. The federal government had to bail out these banks with billions of tax payer money.

            We believe that new proposed FASB and ISAB lease standards will mitigate investment risk by making leasing debt fully visible on the balance sheet. For many companies, particularly retail and other enterprises with vast portfolios of leased properties like fast food outlets, the debt load of their leased properties will be significant. And for entities in the airline industry with large leased fleets, there will be a similar increment to their balance sheets. And even for small companies, who need debt capacity to expand their business, the effects of incremental debt in their financials could negatively impact their ability to secure new debt financing, or even to re-finance current debt.

            The new FASB and IASB lease standards will require diligent management in the transition phase. And yes, the process will incur incremental cost in software, staff resources, and consulting assistance. But the end result will certainly raise the consciousness of senior management about their real estate portfolio, and establish a more detailed understanding of how their real estate practices and portfolio affect the bottom line of their business.