After More than a decade of work, FASB has now released new accounting standards for items (like leases) that should be on a company’s balance sheet. Created in part because of illegitimate lease reporting, like that done by Enron, it’s goal is to create a more standardized approach to lease reporting.
What did Enron do with regards to the leases?
As we know, companies are doing everything they can to come up with new and innovative ways to bolster their stock price. Though leases are similar to loans, companies have long been permitted to exclude most leases from their financial statements. On top of that, sophisticated real estate groups have invented and implemented what’s called synthetic leases. Enron collapsed so quickly in part because of off-balance sheet liabilities, such as synthetic leases (see below for details). Enron had several thousand off-balance sheet affiliates with a cumulative $40 billion in debt. In simple terms, it made their balance sheet look better than it was.
What is the goal of the new lease accounting standards
The goal is to provide more transparency by requiring that all leases appear on the companies’ financial statements, potentially giving investors a more accurate picture of the company’s long-term financial condition.
What Impact will the changes have?
The new Financial Accounting Standards Board (FASB) rules don’t go into effect until 2019; however, I predict that the impending changes will start to affect decision making regarding leases much sooner. Leases that extend through 2019 will have an impact on financial reporting once the standard goes into effect.
Changes in Tenant behavior:
- Tenants will want shorter leases (smaller liability)
- Tenants will want to fund more of the TI work
Impact on landlords
- Since leases will inevitably shorten, property valuations will be facing downward pressure
It will be many years before we know how this plays out. It will be interesting to see how companies react. My belief is that the changes are more positive than negative, and it just seems to make sense. I think the upside, having a more accurate picture of a company’s financial position, outweighs the potential downsides.
Synthetic lease: It’s a financing structure by which a company structures the ownership of the asset so that the asset is owned by a special-purpose entity and leased to the operating company under an operating lease. The lease payments are recorded as an expense on the income statement, instead of being considered a liability. In the US, all leases are classified as either operating or capital leases. In the US only capital leases were to be recognized in an entity’s statement of financial position. The distinction between the two will no longer exists due to the new lease accounting standards.