Leases used to provide fertile ground for accounting manipulation in public companies.
In January 2019, however, the two main accounting standards – GAAP in the US and IFRS everywhere else – introduced new lease accounting standards.
Under GAAP, the new standards for leasing are known as ASC 842, while under IFRS they are known as IFRS 16. In theory, these new standards shut the door on most of the opportunities for manipulating accounts using leases. The impact on balance sheets in some sectors was material, providing insight into the extent to which account manipulation can affect reporting.
Ostensibly, the new standards were meant to curb the most motivated manipulators from leveraging their leases to massage their accounts.
As we will demonstrate, loopholes still exist, particularly in the ASC 842 standard.
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Background: New lease accounting standards
Prior to 2019, there were two classes of leases, financing leases and operating leases. Financing leases were reported on the balance sheet whereas operating leases were not.
Under the new ASC 842 standard for GAAP, the distinction remains but most operating leases must now be reported on the balance sheet.
Under the new IFRS 16 accounting standard, there is no distinction between the two and the definition of a lease is now so broad that even borrowing your partner’s toothbrush might qualify as a lease provided some consideration is given.
Now, under IFRS, anything that looks even remotely like a lease needs to go on the balance sheet. There are two exceptions: Leases under 12 months, and leases where the underlying asset is of low value. We’ll circle back to these in a moment.
Impact of new standards on lease liabilities
When IFRS 16 was first introduced, Ernst & Young examined the impact of the change in lease standards on the reported assets and liabilities in different sectors.
The impact on reported liabilities in some industries such as airlines, retail and apparel, and shipping was large. Liabilities grew by at least 20% in these industries while assets grew by an average of 14%. The impact on liabilities across all sectors was 9% while assets grew by 5%.
Figure I: Impact of IFRS 16 on the balance sheet in different sectors
Source: EY.com
These changes in reported balance sheet size and composition were material and will have impacted the credit rating of some companies.
This is just one facet of accounting. If one facet can shift liabilities by more than 20% in an industry, imagine how much all of the different facets of account manipulation can distort the accounts when they are combined.
The need to report leases on balance sheet will not obviate the use of leases although they are not as attractive as they once were when a synthetic lease gave the lessee the tax benefits of ownership while avoiding depreciation expense. The change in lease accounting standards in 2019 represents the final chapter in the regulatory war on synthetic leases fueled by the collapse of Enron in 2001.
These were still used after 2001 but mostly buried in subsidiaries. Under the new consolidated rules, that option is mostly over-ruled.
Loopholes in new lease accounting standards
But of course, every rule has potential loopholes, and the new lease accounting standards are no exception. Recall our two new accounting standards for leases: ASC 842 under US GAAP, and IFRS 16 under the IFRS standard.
The distinction matters because there is more scope to exploit lease accounting loopholes under ASC 842 than under IFRS 16.
There are at least 10 major differences between the two accounting standards for leases. Under IFRS 16, virtually all leases are finance leases and must be on the balance sheet.
There is more scope to exploit lease accounting loopholes under ASC 842 than under IFRS 16
Under ASC 842, the distinction between financing and operating leases remains but not all operating leases must be reported on the balance sheet. Exemptions exist for leases of inventory, subleases, variable leases, leases of assets under construction (when the lessee does not control the asset before the lease commencement date) and all leases of intangible assets. These can all be held off-balance sheet.
Account manipulators are therefore incentivised to convert as many operating leases as possible into one of these types of leases that are exempt from ASC 842. Even after 2019, companies covered by GAAP still have plenty of scope to lower their reported liabilities using variable and non-commenced leases.
Variable leases under ASC 842
Under a variable lease, the lessee’s payments vary throughout the term due to changing market conditions. There are two main types:
- Index leases: These leases tie the rent to an index of some kind, such as the CPI or a local rental index
- Graduated lease: Under these leases, the lessee and lessor agree to periodic adjustments of monthly payments due to market conditions or a change in the value of the leased asset
ASC 842 allows firms to keep variable leases off-balance-sheet, on the assumption that variable leases were not common and future expenses cannot be estimated reliably.
While variable leases were not a significant feature of the leasing market in 2019, later academic research suggests a shift, that “variable-lease expenses are common and significant; they are as persistent and predictable as operating-lease expenses, and they are not very responsive to changes in revenues.”
The evidence since 2019 suggests that many firms have converted operating leases into variable leases. Importantly, the report finds that, “conservative estimates show that recognition of variable-lease liabilities would increase debt by 8% on average.”
In other words, variable leases allow the average firm using GAAP accounting to hide 8% of its debt.
One can get an approximation of the significance of variable leases for any particular company by looking at their lease expenses in the 10-K filing. In Lululemon’s 10-K filing for 2022, for example, operating lease expenses were US$216 million, while variable lease expenses were US$91 million.
Thus, in this case the amount of lease liability reported on the balance sheet should increase by around 42%. For many companies, variable lease expense now exceeds operating lease expense.
Non-commenced leases under ASC 842
A non-commenced lease is a lease agreement that both the lessor and lessee have signed, but the lessee has not yet started paying rent. In other words, the lease agreement is executed, but the lease term has not yet begun, meaning there is a lag between the contract date and the commencement date.
ASC 842 allows firms to keep non-commenced leases off-balance-sheet, on the assumption that they are relatively rare and will not reflect a firm’s activities in the reporting period.
It is easy enough to find a company’s non-commenced leases if you hunt around in its 10-K filing. They will either be found in a table disclosing yearly lease payments.
Some firms only disclose them in a footnote. Even when non-commenced leases are disclosed in the yearly payments table, they’re often removed from a company’s calculation of the present value of future minimum lease payments, thereby understating the future payments required.
This is legitimate because these lease liabilities can be omitted from the balance sheet - but is it honest accounting?
Non-commenced leases can be significant. Figure II shows that in Twitter’s 10-K filing for Dec 2021, the company has future lease payments of US$1.87 billion, of which US$409 million were non-commenced.
Figure II: Schedule of future lease payments from Twitter’s 10-K filing (Dec 31, 2021)
Source: SEC filings
In other words, almost 40% of the value of the company’s reported operating liability of US$1.07 billion was kept off its balance sheet. The move reduced Twitter’s total liabilities by 6%.
In a quick sample of 20 companies, we found that non-commenced leases lowered the operating lease liabilities by 20-to-30% on average, and lowered total liabilities by an average of 4.1%.
These numbers are material.
In summary, although the new lease standards represent a marked improvement from the previous situation, companies covered by GAAP still have plenty of scope to lower their reported liabilities using variable and non-commenced leases. Sub-leasing and leasing of intangibles between companies and their subsidiaries will also provide a wealth of opportunities.
