What you will learn to do: Understand accounting for leases

One of the newest areas of concern for the FASB has been “off balance sheet” financing, such as leases. Up until 2020, GAAP classified leases, which are essentially long-term rental agreements, as either a capital lease or an operating lease. The basic difference between the two was one of ownership. For instance, if you leased a vehicle for five years and then took ownership at the end of the five years, that would be a capital lease. If at the end of the five years there was some huge residual payment that you would have to pay to take ownership, it was an operating lease.

Under the old rules, the lessee (the organization that is renting or leasing the asset), treated a capital lease as debt with a resulting asset and liability, just as if the company had purchased the asset using a note payable. Rental payments on an operating lease were treated as monthly expenses with no asset.

In 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2016-02, Leases. It took effect for publicly traded companies in 2018 and 2019 and for non-public companies in 2020.

The new standard provides for a dual approach for lessee accounting, with leases that transfer substantially all the risks and rewards incidental to ownership as finance leases, with remaining leases accounted for as operating leases.

Accounting for a finance lease is similar to the old capital lease rules. The asset and related lease liability are recognized at the present value of the future lease payments and the debt (the lease) is a long-term liability with a short-term component.

Under the new rules, an operating lease also results in the recognition of a right-to-use asset (which we saw in the module on non-current assets) and a lease obligation.

The change may seem slight and technical, but it is significant. If we look back at The Home Depot’s list of assets, we see that in 2020, when the new rule took effect, the company added almost $6 billion ($5,595 million) in operating lease right-of-use assets, and we see an addition $828 million in current operating lease liabilities (the rest of the lease liability is in non-current liabilities not shown here). Although the additional debt is offset by additional assets, you can see that prior to the new rule, The Home Depot had $6 billion in assets that were financed by debt in the form of lease agreements that were not being shown. It wasn’t fraud, it was just that GAAP didn’t require or even allow companies to recognize those assets.

That’s why GAAP is constantly changing and adapting and also why, as accountants, we have to stay current on what is going on in the industry.

See the balance sheets long description here.

In addition, we see that long-term operating lease liabilities increased by $5.066 billion, and the total of the additional assets ($5.595 billion) is very close to the additional new debt recognized ($0.828 billion in current liabilities and $5.066 billion in long-term liabilities). The difference is most likely attributable to amortization of the lease liability and depreciation on the right-to-use assets. In any case, the liability existed before the accounting pronouncement–it is now being recognized and shown on the balance sheet and for The Home Depot, it is not an insignificant amount.