Accounting for Operating Leases

Initial Observations

By: Stephen H. Fuller, PhD, Pranav Ghai and Ariel Markelevich, PhD, CMA

This article examines the initial impact of the adoption of ASU 2016-02 (ASC Topic 842, Leases), which requires lessees to record assets and liabilities for operating leases. Under prior standards, operating lease payments were simply expensed as incurred. Under the new guidance, entities must report a liability representing the amount owed under the lease agreement and a right-of-use (ROU) asset that represents the benefits derived from use of the leased asset over the term of the lease. The standard impacts not only the balance sheet, but also some commonly used financial ratios (e.g., debt to equity, return on assets).

The analysis shows that the impact of ASC Topic 842 has not been uniform across companies and industries. Across all public companies, a relatively insignificant average impact on balance sheet amounts and related financial ratios was observed. Significant effects on balance sheet amounts and financial ratio, however, are observed at the industry and individual company levels where leased assets are employed extensively. In addition, companies employed a fairly broad range of discount rates in calculating the values of their operating lease liabilities. Finally, a rash of impairments of newly recorded ROU assets was observed shortly after ASC 842 was implemented, which reduced the comparability of financial statements during this time and will likely result in future earnings volatility for those affected. Accordingly, investors, analysts, and other financial statement users will have to be careful to consider these impacts on financial statements during the transition.

Background

Debates over the proper accounting for so-called operating leases have been around for decades. These leases, which tend to have durations significantly shorter than the life of the underlying assets, were essentially ignored on companies’ balance sheets and treated as ongoing expense payments as incurred. Critics of this treatment suggested that these leases amounted to major obligations for the lessees that were not reported as the debt-type liabilities that they resemble, impairing comparability with companies financing their operating assets through debt.

The many proponents of expensing operating lease payments as incurred had reasons to prefer the treatment. Chief among them was that companies enjoyed the ability to keep the financing provided by the leases off the balance sheet. In doing so, companies enjoyed greater flexibility in future financing decisions as well as more attractive ratios in a number of key areas such as solvency, leverage, and operating returns. Operating lease treatment also provided for smooth and predictable expense patterns, as opposed to the combination of interest and depreciation that varied over the life of a capitalized lease, with the greatest expense occurring at the beginning of the asset’s life.

In response to this longstanding debate, FASB issued ASU 2016-02 in 2016, creating a new topic in the Accounting Standards Codification, ASC Topic 842, Leases. Under the new guidance, for all leases longer than one year, companies must record a lease liability and a corresponding ROU asset, generally based on the present value of lease payments over the term of the lease at an appropriate discount rate. Under the new standard, expenses for operating leases are recognized over the term of the lease based on a straight-line method approach. For leases shorter than one year, lessees can elect not to record lease liabilities and ROU assets and instead recognize the expense associated with the lease payments using the straight-line basis.

The first widespread implementation of the revised standards is well underway. Most public companies were required to adopt the standard no later than for fiscal years beginning after December 15, 2018, including their quarterly filings. Accordingly, many companies began reporting lease liabilities and ROU assets beginning with their first calendar-quarter filings in 2019, giving analysts an opportunity to look at the early impacts of the new standard on companies’ financial reporting. The next section describes the authors’ data collection procedures and summarizes early findings regarding the impact of the revised standards on financial reporting. We first report the average impact for all companies and then select several specific industry sectors affected in different ways by the standard.

Data Collection and Findings

Using data provided by Calcbench (http://www.calcbench.com), we examine public companies’ financial statement information reported for the second calendar quarter of 2019. Specifically, the authors collected data for companies with a fiscal year starting after December 15, 2018, that filed 10-Qs with a period end date between May 16, 2019, and August 15, 2019; 625 companies that reported in this period were not required to adopt ASC 842 (because their fiscal year started before December 15, 2018) and were excluded from this study. Only companies with more than $1,000,000 in assets were included to filter out non-operating companies, shell companies, and the like. This time period was chosen to maximize the number of companies included that would have adopted ASC 842. As shown in Exhibit 1, out of the 4,194 companies included in this survey, 3,392 reported operating lease liabilities in their balance sheets (80.9%). Of the companies reporting operating lease liabilities, 4% reported no ROU assets. Many of the entities that reported no operating lease liabilities or ROU assets were classified as emerging growth companies, which are not required to implement ASC 842 for another year. The other primary reasons companies reported no separate values for operating lease liabilities or ROU assets—or both—are immateriality of the amounts, a true lack of the assets or liabilities, or company error. Although most companies are impacted by the standard, the total amount of operating lease liabilities reported represents only 2.46% of total liabilities, and the total amount of ROU assets reported represents only 1.80% of total assets for those companies. In other words, although the standard impacted more than three-quarters of all companies, the average impact on their assets and liabilities is quite small. Predictably, these small impacts on total assets and total liabilities led to similarly small impacts on related financial ratios. ROA for companies in the impacted sample was 2.49%, compared to 2.53% when ROA was adjusted to exclude the ROU assets reported under ASC 842. Similarly, the debt-to-equity (D/E) ratio for companies reporting operating lease liabilities was 3.55, compared to 3.46 when the D/E ratio for these companies was adjusted to exclude the reported operating lease liabilities. Considering the time and attention given to the debate over the reporting of operating leases over the last several decades, the cross-sectional impact of the leasing standard on financial reporting is underwhelming. When re-examined at an industry level, however, significant impacts emerge in industries more reliant on leased assets.

Industry Data Analysis

In order to explore industry-level impacts of the lease standard, the sample was analyzed at the 4-digit Standard Industrial Classification (SIC) code level. Sample companies identified themselves with a total of 385 industries; within these industries, the number of companies ranged from as few as 1 to as many as 389 companies. To emphasize industries with a meaningful number of participants, the analysis focused on industries with greater than 25 companies (Exhibit 2). The industries were ranked from highest to lowest in terms of operating lease liabilities reported as a percentage of total liabilities. The following discussion focuses on the three industries least affected by the lease standard, and the three most impacted.

The industry analysis was focused on the following industries that were least affected by the standard:

• SIC 2834—Pharmaceutical preparations
• SIC 4911—Electric services
• SIC 6021—National commercial banks

The following industries were most affected:

• SIC 5812—Retail–eating places
• SIC 8742—Services–management consulting services
• SIC 7372—Services–prepackaged software

As shown in Exhibit 3, the industries least affected by the standard look much like the sample as a whole. The lease standard has very little impact on either the balance sheet amounts reported or the associated ratios. Operating lease liabilities for the three industries selected made up no more than 1.75% of total liabilities, and ROU assets made up no more than 1.10% of total assets for the companies that adopted ASC 842. In addition, as shown in Exhibit 3, adoption had virtually no effect on ratios such as ROA and D/E, which did not change significantly when ROU assets and operating lease liabilities were excluded from those ratios, respectively.

In addition to the industries in Exhibit 3, we further reviewed all other industries and observed that three types of industries were least affected by the lease standard: financial service providers, manufacturers, and energy and sanitation service providers. For further context, almost 69% of the companies in the sample operate in industries with operating lease liabilities comprising less than 5% of total liabilities.

To really see the potential impact of the new standard, the authors selected three industries that rely to a heavier degree on leased assets. The retail–eating places industry was most dependent upon leased assets. A well-known example is Chipotle Mexican Grill Inc, whose financial statements were significantly impacted by the new standard. Like so many other retailers, the company relies heavily on operating leases for many of its retail store locations and office space. As of the end of Chipotle’s second quarter, the company reported approximately $2.37 billion of ROU assets (50.9% of total assets) and approximately $2.70 billion of operating lease liabilities (86.4% of total liabilities). Total liabilities for the company increased 279% from pre-ASC 842 levels.

The industry as a whole also felt a significant impact from adoption of the standard. Operating lease liabilities made up 23.4% of total liabilities and ROU assets made up 21.5% of total assets for impacted companies in the sample. In addition, as illustrated in Exhibit 4, adoption of the lease standard had significant effects on ROA and D/E. Return on assets (ROA) was negatively impacted by the addition of ROU assets. ROA was 8.29%, compared to 10.55% if ROU assets were excluded from the calculation. The D/E ratio increased to 49.04, compared to 37.55 if operating lease liabilities were excluded from the calculation.

The other selected industries with high dependence on operating leases—albeit significantly less than retail–eating places—were management consulting services and prepack-aged software. Each of these industries was impacted by the lease standard to a significantly lesser extent than retail eating places. Operating lease liabilities were 13.02% and 9.08% of total liabilities, and ROU assets were 6.39% and 4.76% of total assets, respectively, for the management consulting services and prepackaged software industries. The impacts of the lease standard on ROA and D/E ratio for management consulting services and prepackaged software were similarly modest compared to the retail–eating places industry.

A detailed review of all industries confirms that three types of industries were overwhelmingly the most affected by the lease standard: retailers, service providers, and consumer products. In particular, there are certain smaller industries in the retail sector where operating lease liabilities comprise as much as 40–50% of total liabilities. Nonetheless, to give an overall idea of the extent of companies significantly impacted by the lease standard, only 17% of the total sample were from industries with operating lease liabilities greater than 10% of total liabilities.

Discount Rates

In addition to the operating lease liabilities and ROU assets associated with adoption of ASC 842, most companies also reported the weighted average discount rate associated with their operating lease liabilities. Of the 3,392 companies in the sample that reported operating lease liabilities, 2,907 reported the discount rate. As summarized in Exhibit 5, discount rates ranged broadly, with an expected high concentration of rates between 3% and 6%; the mean discount rate for the sample was 5.86%, while the minimum rate was 0% and the maximum was 48%. One critical element of discount rates to consider is their inverse relationship with the operating lease liability—the higher the discount rate, the lower the operating lease liability. So, counterintuitively, companies that are the least creditworthy and therefore have the highest discount rates report the lowest operating lease liabilities, all other things being equal.

Impairments of ROU Assets

One perhaps surprising outcome from the adoption of the leasing standard has been the significant number of impairments that have been recorded for newly recorded ROU assets. The authors searched the Calcbench database for the first three quarters of calendar 2019 for impairments of ROU assets. As shown in Exhibit 6, there were consistent and significant numbers of ROU asset impairments in the first three quarters of 2019. Altogether, 121 impairments totaling $1.7 billion were reported by companies in their XBRL filings over that period. Such impairments have compound effects on the financial statements. For example, net income is not only depressed in the period of impairment; it is enhanced in subsequent periods when the asset has a lower value or no value to be amortized to expense. It remains to be seen whether this effect will dissipate over time as these “problem” leases likely accumulated over time and adoption of the standard proved to be the catalyst for a large concentration of impairments over a short period of time. Regardless, any future impairments will lead to further earnings volatility in the period of impairment and subsequent periods.

Looking Closer

Although the adoption of ASC 842 appears to be having a relatively small impact on public company financial statements, the authors’ survey found evidence of significant effects in specific areas. First, for industries and individual companies that rely more heavily on leased assets, financial statement amounts and financial ratios were significantly impacted by adoption of the new guidance. In addition, the authors found a fairly diverse range of discount rates being used in the calculation of operating lease liabilities. To the extent that companies with comparable credit profiles use diverse discount rates for their leases, the comparability of financial reporting could diminish. Furthermore, the authors observed a significant trend of ROU asset impairments, introducing earnings volatility to the financial statements in both the period of the impairment and beyond. Such threats to financial statement comparability will need to be carefully considered by investors, analysts, and other financial statement users as the adoption of ASC 842 continues across all companies. Finally, although the authors’ focus was on the modest impact of the lease standard on the financial statements of most companies, this should not diminish the burden companies have faced in implementing the standard, which, by all accounts, has been considerable.

Stephen H. Fuller, PhD, is an assistant professor of accounting at Suffolk University, Boston, Mass.

Pranav Ghai is the Chief Executive Officer of Calcbench, Inc., New York, N.Y.

Ariel Markelevich, PhD, CMA, is an associate professor of accounting, also at Suffolk University.