Accounting standards authorities have long struggled with leases: Are they an essential aspect of corporate performance, or a marginal one? Should they be highly visible or can they be safely tucked away? Leases \u2014 a contract allowing the use of an asset, property or service for a fixed period of time in exchange for regular payments \u2014 are ubiquitous in corporate America. Accounting standards in recent decades treated them differently: Capital leases (also known as finance leases) were included on balance sheets and operating leases were left off, often reappearing, if at all, in obscure footnotes. Why the difference? In a capital lease, the asset may be transferred to the lessee at the end of the term, like a car that\u2019s leased with the option to buy; in an operating lease, the owner retains control throughout \u2014 say, of an office building with multiple tenants or a data center with many customers.<\/p>\n
Operating leases have become a common component of off-balance-sheet liabilities. Some sectors such as retail or casual dining and fast food with multiple outlets or airlines with fleets of leased aircraft carry large amounts of operating leases. In recent decades, off-balance-sheet liabilities in general have been blamed for a variety of financial woes and as a source of mismanagement at best, malfeasance at worst; the financial crisis of 2008\u2013\u201909 and Enron Corp.\u2019s 2001 collapse are examples of the former and the latter, respectively.<\/p>\n
Critics argued that liabilities off the balance sheet reduce transparency and comparability for investors, and\u00a0encourage suboptimal capital allocation and decision-making by management<\/a>.1<\/sup>\u00a0The Financial Accounting Standards Board (FASB), the private, nonprofit organization that establishes rules for generally accepted accounting principles (GAAP) in the U.S., began to seriously discuss off-balance-sheet liabilities in 2006 and focused specifically on lease obligations \u2014 meaning operating leases. In the decade that followed,\u00a0FASB engaged<\/a>\u00a0in research, debate, multiple exposure drafts, comment periods and educational sessions on new rules for lease accounting.2<\/sup><\/p>\n The goal of the new rules was straightforward. \u201cIt puts things in a more transparent condition,\u201d FASB vice chairman James Kroeker\u00a0told the\u00a0Wall Street Journal<\/em><\/a>\u00a0in 2016, when the organization released a new standard on off-balance-sheet lease recognition for the first time. He noted that the rule \u201cadds light to one of the last remaining crevasses of off-balance-sheet accounting.\u201d3<\/sup>\u00a0As accounting firm\u00a0Deloitte said<\/a>\u00a0in the run-up to the new standard, \u201cWe expect the standard will have far-reaching implications in areas such as accounting, finance and reporting, real estate, tax and technology, among others.\u201d4<\/sup>\u00a0These changes were certain to affect not only directors, executives and workers but analysts, investors and the financial media \u2014 everyone trying to more precisely understand and value public corporations. The reforms should make the market more efficient.<\/p>\n The lobbying was intense to the point of hysteria. LeaseAccelerator, a firm that sells software for leasing, called the looming implementation of new leasing standards, \u201cthe lease-pocalypse.\u201d A\u00a02012 study<\/a>\u00a0by Chang & Adams Consulting predicted that the change would affect some $1.5 trillion in leases in the U.S., equal to the gross state product of 20 states, and destroy between 190,000 and 3.3 million jobs while slashing gross domestic product and household wealth.5<\/sup>\u00a0The study was commissioned by a group of real estate operators, homebuilders and the U.S. Chamber of Commerce. Others feared that credit rating agencies would downgrade ratings because of the\u00a0increased debt load from operating leases<\/a>.6<\/sup>\u00a0Still others\u00a0worried about covenants and credit agreements<\/a>\u00a0running afoul of rising leverage ratios from the inclusion of operating leases.7<\/sup><\/p>\n Nearly three years later, on January 1, 2019, FASB implemented the new accounting standards update (ASU). The long-awaited rule mandated that leases appear on balance sheets as debt at the present value of future debt payments. This affected a wide range of other financial metrics; implementation of the new standard amounted to the largest restatement of financial assets in recent history.\u00a0Approximately $3 trillion<\/a>\u00a0in operating leases had to be accounted for, which meant that balance sheets across the investable U.S. market would expand by approximately 10 percent, in aggregate, with some companies seeing increases that were multiples of that.8<\/sup><\/p>\n And yet, like the fears about Y2K at the turn of the century, the lease-pocalypse never arrived. For all the disruptive potential, implementation has proceeded relatively smoothly. This was helped by the long lead time and the decision to give smaller and private companies an extra year to comply. A number of companies, including Microsoft, made the changes before the 2019 implementation. Many others offered guidance about what the new balance sheets would look like. And it may also be attributable to the sophistication of financial, investment and corporate players. Accounting, after all, is just a tool companies use to report their status to stakeholders, particularly investors. It provides snapshots of organizations that are constantly evolving. The act of moving operating leases onto balance sheets does not alter company fundamentals. In many cases, these numbers had been available \u2014 as they were for credit rating agencies like Moody\u2019s \u2014 if you knew where to look. In fact, many analysts and investors know exactly where to look.<\/p>\n Of course, there may be other explanations for the lack of major disruptions \u2014 not to say job losses and evaporating GDP. The year 2019 saw a remarkably bullish U.S. stock market, which may have cushioned some of the effect of these changes. Low interest rates take some of the sting from the appearance of greater leverage. As economic conditions change, the sensitivity toward debt and leverage may increase. Still, in hindsight, the accounting technocrats at FASB may well feel blessed that the agency chose a year like 2019 to implement these accounting changes.<\/p>\n Change on leases has been a long time coming. The issue of how to account for operating leases was first addressed in the U.S. in 1949, when the Committee on Accounting Procedure determined that operating lease accounting should not be used for long-term leases \u2014 effectively endorsing off-balance-sheet financing for most leases. FASB crystallized the treatment of off-balance-sheet financing in 1976 with a policy statement,\u00a0Financial Accounting Standards (FAS) No. 13<\/a>, now known as Accounting Standards Codification Topic 840 (ASC 840). These standards became effective on January 1, 1977.9<\/sup><\/p>\n Until the late 1990s, the growing practice of off-balance-sheet financing seemed to be relatively benign. At the turn of the century, however, Enron changed everything. The Houston-based natural-gas-producer-turned-energy-trader hid huge losses and fabricated earnings through a bewildering array of off-balance-sheet special-purpose entities, resulting in the bankruptcy of the corporation, the failure of its accounting firm and a raft of criminal charges and convictions for senior executives.<\/p>\n Enron and a handful of other corporate scandals provoked demands for increased transparency and an enhanced ability to compare companies, but the development of new accounting rules takes time. In 2006, just before the financial crisis, which featured its own off-balance-sheet disasters, FASB and International Financial Reporting Standards (IFRS) began work on new rules to bring operating leases onto balance sheets. In 2011,\u00a0Barron\u2019s<\/em>\u00a0wrote<\/a>\u00a0that \u201caccounting for leases has become a hot topic in finance departments of major U.S. corporations, and could become one for Wall Street as well.\u201d10<\/sup>\u00a0The topic was so hot that\u00a0Barron\u2019s<\/em>\u00a0never returned to it. In fact, although the magazine predicted that the new rules might be out by 2013, it took until 2016 to publish\u00a0ASC 842<\/a>11\u00a0<\/sup>and IFRS 16, and implementation of the standards under GAAP and IFRS did not begin until 2019.<\/p>\n All that\u2019s not to say that implementation was not a challenge, particularly since FASB also asked financial institutions to\u00a0adopt new standards<\/a>\u00a0for recognizing credit losses, hedging and long-duration insurance contracts in the same time period.12<\/sup>\u00a0The details of the lease standard are highly technical, and companies and their accountants struggled with delays and software snafus. Several years ago, accounting firm\u00a0PwC<\/a>\u00a0noted that lease information was highly decentralized at 39 percent of the companies it surveyed.13<\/sup>\u00a0Most respondents said data collection, not accounting or tax issues, would be the greatest challenge. A\u00a0survey by Deloitte<\/a>\u00a0early last year found that despite the long run-up, only 30 percent of private companies planned to implement the standard on schedule, while 33 percent admitted they were unprepared to comply and 44 percent said they were \u201csomewhat\u201d prepared.14<\/sup>\u00a0As a result, FASB voted unanimously in mid-July to push back the implementation date for small companies, private companies, small banks and insurers for a year, until January 2021. (FASB often gives smaller and private institutions, which have fewer resources, more time to implement major changes.)<\/p>\n Despite the broad common interests of regulatory agencies around the world and the initial intent to hammer out a uniform global rule, U.S. GAAP and the IFRS lease standards have significant differences. Some of these reflect practices and challenges that vary by region. A\u00a02016 study by IFRS<\/a>\u00a0revealed that while 62 percent of companies in North America disclose off-balance-sheet leases, only 47 percent of European companies, 43 percent of Asian businesses and 23 percent of Latin American and African companies do so.15<\/sup><\/p>\n Although balance sheet comparability for some metrics appears to be converging for GAAP and IFRS, income and cash flow statements are diverging. And while transparency across all companies has improved, transparency across regions remains elusive. GAAP, for instance, retains operating leases and therefore rent expenses on profit-and-loss and cash flow statements. However, under IFRS, which applies to companies in 140 countries, leases are recorded as amortization and interest expenses. This creates a front-end-loaded expense trajectory, in contrast to straight-line expensing under GAAP.<\/p>\n Every company that choses to lease rather than buy will see its balance sheet expand because of the need to account for operating leases. Under the new standard, companies book operating and finance leases over a month in length as liabilities, based on the net present value of lease payments and financing, and as an addition to assets. This reflects their ability to use the lease, whether it\u2019s on a factory, office building or a fleet of airplanes.<\/p>\n A November 2018 McKinsey & Co. study highlighted three industries (out of 21) that will experience the biggest change: Broad retailing has seen debt rise by an average of 64 percent, with food and staples retailing and transportation growing by 55 percent and 40.3 percent, respectively.16<\/sup>\u00a0Industries including energy, pharmaceuticals and biotechnology, semiconductors and equipment, food, beverage, tobacco and utilities have seen increases of around 5 percent.<\/p>\n A\u00a0July 2018 study<\/a>\u00a0by LeaseAccelerator ranked the top 1,000 U.S. companies by their operating lease liabilities, using data on operating leases found in the footnotes of the companies\u2019 financial statements.17\u00a0<\/sup>Not surprisingly, the study found that certain industries would have a greater exposure to the change: airlines, which lease not only planes but terminal space, gates and baggage handling areas; real estate investment trusts; food services; general merchandise; and apparel retailers with extensive stores and warehouses.<\/p>\n A major accounting shift may have very different effects on investors with varied goals, sensitivities and skills. As LeaseAccelerator dryly notes: \u201cMost sophisticated institutional investors have studied these off-balance-sheet leases and factored them into their financial models. However, there is ongoing concern that smaller, individual investors might not be considering these additional leasing obligations when making decisions about which stocks or bonds to purchase for their retirement fund or college savings.\u201d Reported total assets and liabilities of portfolio companies will rise, and in some cases balloon, compared with previous accounting periods. As a result, many metrics investors use to evaluate risk, efficiency, financial health, valuation and other aspects of corporate operations will change. In July 2019,\u00a0Credit Suisse warned<\/a>\u00a0that \u2014 given the sheer magnitude of the impact \u2014 misleading data feeds, inconsistent financial reporting and other discrepancies \u201ccould confuse and misinform investors.\u201d18<\/sup>\u00a0Because accounting statements are so essential in analyzing companies, these changes may tell a very different story, even though underlying fundamentals and operations have not changed at all.<\/p>\n Many of the most important risk models employed in money management, including MSCI\u2019s widely used Barra Risk Factor models, provide information to investors on the embedded factor exposures in their investment portfolios. Factors quantify exposures that are not idiosyncratic to the individual stocks in the investment portfolio. Examples of this include momentum, volatility, quality and size. All factor exposures are derived from financial ratios, and quality exposure is materially affected by the new standard, as debt to equity is one of the underlying ratios.<\/p>\n Outside of portfolio construction and risk management, the new standard makes traditional investment analysis more challenging. Companies are not required to restate their historical financial statements for the new accounting changes, so it will be difficult in some cases to compare the balance sheet items before and after the accounting rule change.<\/p>\n Moody\u2019s Investors Service, for instance,\u00a0announced<\/a>\u00a0in August 2018 that although it had long brought operating lease obligations onto its balance sheets when evaluating a company, it would in the future use company estimates, which it said would be more accurate.19<\/sup>\u00a0As for problems with covenants and credit agreements, many companies, at the urging of their accountants, may have amended those agreements based on the new standard. As it turns out, many credit agreements had\u00a0existing provisions<\/a>\u00a0that said operating leases should not be treated as debt, no matter where they appeared.20<\/sup><\/p>\n Moreover, although companies are not required to historically restate their financials, they must release the same footnotes; this allows investors to compare past statements with current disclosures and results. Specifically, the \u201cCommitments and Contingencies\u201d footnotes outline companies\u2019 capital lease obligations due in tranches over the next five years and the cumulative obligations thereafter. Investors can use this information and apply a discount rate for the company to derive a net present value of operating lease obligations and create adjusted asset and liability values. While the analysis is not perfectly comparable, it should be close enough to create like-to-like comparisons of new and old data.<\/p>\n C-suite executives will have more urgent and increased transparency around financial metrics that more accurately reflect the fundamental performance and health of their businesses. Management teams\u2019 compensation packages are heavily reliant on hitting milestones associated with their financial statements, such as earnings or cash flow growth and specific share prices.<\/p>\n FASB\u2019s accounting standard change on leases takes further steps to increase transparency for investors and corporate managers. It represents a significant advance in improving the comparability of companies with similar structures that choose to fund their businesses in different ways. It may also improve corporate governance and hold management teams more accountable for the obligations they underwrite to fund their companies.<\/p>\n In retrospect, the rollout of the new standard may well be viewed, for all the fears and delays, as a model. From FASB\u2019s perspective, part of that success was that it did not provoke major headlines; it did not roil markets. Instead, helped by a beneficent economic climate and rising markets, the implementation process appeared to suggest that companies and investors were both sophisticated and relatively well prepared for the change. Was there a lease-pocalypse? Not really. But it may well be, again like Y2K, that we avoided massive disruption by its very possibility.<\/p>\n B. Korcan Ak<\/strong><\/span> is a Vice President, Data and Investment Strategy, at WorldQuant and has a PhD in business administration from Haas School of Business, University of California, Berkeley.<\/em><\/p>\n Jeffrey Messina<\/strong><\/span> is a Managing Director at WorldQuant and has a BA in economics from Colby College.<\/em><\/p>\n","endnotes":" Thought Leadership articles are prepared by and are the property of WorldQuant, LLC, and are being made available for informational and educational purposes only. This article is not intended to relate to any specific investment strategy or product, nor does this article constitute investment advice or convey an offer to sell, or the solicitation of an offer to buy, any securities or other financial products. In addition, the information contained in any article is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice. WorldQuant makes no warranties or representations, express or implied, regarding the accuracy or adequacy of any information, and you accept all risks in relying on such information. The views expressed herein are solely those of WorldQuant as of the date of this article and are subject to change without notice. No assurances can be given that any aims, assumptions, expectations and\/or goals described in this article will be realized or that the activities described in the article did or will continue at all or in the same manner as they were conducted during the period covered by this article. WorldQuant does not undertake to advise you of any changes in the views expressed herein. WorldQuant and its affiliates are involved in a wide range of securities trading and investment activities, and may have a significant financial interest in one or more securities or financial products discussed in the articles.<\/p>\n","ideas_panel":{"ideas_panel":{"heading":"Keep reading","subheading":"","articles":[{"ID":649,"post_author":"5","post_date":"2020-03-31 22:23:11","post_date_gmt":"2020-03-31 22:23:11","post_content":"","post_title":"Modern Challenges in Company Classification","post_excerpt":"","post_status":"publish","comment_status":"closed","ping_status":"closed","post_password":"","post_name":"modern-challenges-in-company-classification","to_ping":"","pinged":"","post_modified":"2025-11-24 18:20:25","post_modified_gmt":"2025-11-24 18:20:25","post_content_filtered":"","post_parent":0,"guid":"https:\/\/wdqnt.wpengine.com\/?post_type=idea&p=649","menu_order":0,"post_type":"idea","post_mime_type":"","comment_count":"0","filter":"raw"},{"ID":697,"post_author":"5","post_date":"2018-12-26 20:50:07","post_date_gmt":"2018-12-26 20:50:07","post_content":"","post_title":"The Evolution of The Long March to Leasing Standards<\/strong><\/h3>\n
The New Look of Leases and Balance Sheets<\/strong><\/h3>\n
Navigating the New Standard<\/strong><\/h3>\n
Conclusion<\/strong><\/h3>\n
\n
Market Microstructure","post_excerpt":"","post_status":"publish","comment_status":"closed","ping_status":"closed","post_password":"","post_name":"informed-vs-uninformed-the-evolution-of-market-microstructure","to_ping":"","pinged":"","post_modified":"2025-11-24 18:13:48","post_modified_gmt":"2025-11-24 18:13:48","post_content_filtered":"","post_parent":0,"guid":"https:\/\/wdqnt.wpengine.com\/?post_type=idea&p=697","menu_order":0,"post_type":"idea","post_mime_type":"","comment_count":"0","filter":"raw"},{"ID":546,"post_author":"5","post_date":"2021-12-15 18:43:39","post_date_gmt":"2021-12-15 18:43:39","post_content":"","post_title":"Using AI to Tackle
the ESG Data Challenge","post_excerpt":"","post_status":"publish","comment_status":"closed","ping_status":"closed","post_password":"","post_name":"using-ai-to-tackle-the-esg-data-challenge","to_ping":"","pinged":"","post_modified":"2025-11-24 18:18:46","post_modified_gmt":"2025-11-24 18:18:46","post_content_filtered":"","post_parent":0,"guid":"https:\/\/wdqnt.wpengine.com\/?post_type=idea&p=546","menu_order":0,"post_type":"idea","post_mime_type":"","comment_count":"0","filter":"raw"}],"see_more_link":""}},"pdf_file":false},"yoast_head":"\n