The new lease accounting standard ASU 2016-02, Lease (Topic 842), codified as ASC 842, requires firms to recognize both finance and operating leases on their balance sheets. However, the Financial Accounting Standards Board (FASB) made an exception for leases with variable payments, which can still be kept off-balance-sheet, affecting a sizable portion of total lease costs in some industries. FASB attributed this decision to the feedback from companies about the difficulty of reliably estimating variable-lease payments, which could vary over time due to changes in the economic activity associated with the leased asset. This study performs several interrelated analyses to examine the properties of variable leases and the consequences of keeping variable-lease costs off-balance-sheet.
Accounting for Leases under U.S. GAAP
Leases typically involve two parties: the lessee (i.e., the party obtaining the right to use the property) and the lessor (i.e., the party conveying the right to use the property). The old lease accounting standard described in ASC 840 distinguished between capital leases (known as finance leases under ASC 842) and operating leases. Capital leases had to be recorded on the lessee’s balance sheet. In contrast, operating leases were not recorded on the lessee’s balance sheet, potentially creating incentives for firms to strategically structure lease arrangements to keep them off-balance-sheet. In response to these concerns, the FASB began working on a new lease accounting standard in the mid-2000s and, in March 2009, published the first Discussion Paper introducing the idea of recording operating leases on the lessee’s balance sheet. After several rounds of feedback, the FASB passed the new lease standard ASC 842 in 2016 “to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements.”
Under the new standard, lessees were required to report finance and operating leases on their balance sheets; variable leases could remain off-balance-sheet. Variable leases are lease arrangements in which the lease payments are linked to the usage of the leased assets or revenues generated by the leased assets. For example, airlines often lease gates and ticket counters at airports, and the lease expenses for these assets typically depend on passenger traffic (i.e., the use of these assets). Similarly, retailers may lease stores in malls, and banks may lease branches, using variable leases in which the lease expenses depend on customer traffic or revenues generated at each location. However, ASC 842 requires firms to disclose their period lease expenses, including variable-lease expenses, in the footnotes of their financial statements. The new standard applied to financial statements released by publicly listed firms (except for emerging growth companies) for fiscal years beginning after December 15, 2018.
In its 2010 Exposure Draft of the new lease standard, the FASB proposed recognizing variable leases on the balance sheet, using a probability-weighted estimate, arguing that “such contingent rentals meet the definition of a liability” and pointing out that lessor and lessee typically have “some level of understanding about the likely amount of payments” (page 105, IASB/FASB (2010)). The FASB also noted that “in the board’s view, the liability to pay contingent rentals and the right to receive lease payments exist at the date of inception of the lease. Such contingent rentals meet the definition of liability for the lessee and an asset for the lessor. It is only the amount to be paid that is uncertain” (Section BC123, IASB/FASB (2010)).
The FASB, however, received feedback from preparers and users disagreeing with the proposal to record variable leases on the balance sheet (FASB, 2016). Preparers argued that the proposed approach would be very costly to apply, especially for longer-term leases with payments linked to the lessee’s performance or the use of the underlying asset, because it is very difficult to predict the future associated performance with the leased asset reliably. At the same time, some FASB board members pointed out that excluding variable-lease payments from the measurement of lease assets and liabilities could incentivize firms to structure leases as variable leases. The FASB ultimately deferred to the feedback and eliminated the requirement to record variable leases on the lessee’s balance sheet.
Thus, a central assumption underlying the differential treatment of variable leases is that they exhibit very different properties than operating and finance leases. Variable leases are presumed to be less persistent, less predictable, and more variable.
Empirically, we examine whether and to what degree the properties of variable-lease expenses differ from those of operating-lease and finance-lease expenses. For these analyses, we collect firms’ disclosed period expenses associated with operating, finance, and variable leases, which they must disclose in their footnotes under the new standard. Our sample includes all publicly listed U.S. firms belonging to the Russell 3000 index in any given year between 2015 and 2021.
We document that variable-lease expenses exhibit a high degree of persistence, very close to operating-lease and finance-lease expenses. Similarly, the predictability of expenses from variable leases is similar to those from operating and finance leases. Finally, we show that, while variable leases are somewhat more responsive to changes in underlying economic conditions, their elasticity to revenues is economically small. Overall, our first set of analyses provides robust and consistent evidence suggesting that variable-lease expenses exhibit properties similar to operating-lease and finance-lease expenses, contradicting one of the main assumptions underlying the new standard’s differential treatment of variable leases.
Our second set of analyses focuses on the potential consequences for firms and investors of the new standard’s differential treatment of variable leases. A concern raised by standard setters was the possibility that firms could restructure operating leases and classify them as variable leases to reduce their liabilities (IASB/FASB, 2010). However, we do not find evidence supporting firms restructuring their operating leases to keep them off-balance-sheet.
We also analyze the impact of ASC 842 on firms’ equity betas and credit ratings. We do not find evidence that equity betas or credit ratings capture variation in the relative importance of variable-lease expenses. We offer a methodology that can help users of financial statements derive conservative estimates of the off-balance-sheet liabilities associated with variable-lease payments. Our methodology relies on the observation that operating-lease costs represent a useful anchor for variable-lease costs and combines the ratio between the two lease costs with firms’ reported operating-lease liabilities.
Our estimates indicate that recognizing variable-lease liabilities on firms’ balance sheets would add approximately $206 million in debt for the average firm with variable leases, representing an increase in total debt of 7.7%. These magnitudes vary drastically by industry. For example, recognizing variable leases would increase debt by more than 10% for firms with variable leases in the consumer durables, food & staples retailing, and transportation industries and by more than 13% in the retailing and pharmaceutical industries. Off-balance-sheet liabilities associated with variable leases can therefore be economically important and relevant to users of financial statements.
Our results support the view that variable-lease payments can be predicted reliably because the economic drivers tied to variable-lease payments are persistent and predictable. Given the persistence and predictability of variable-lease expenses, our findings thus call into question the current practice of keeping variable-lease liabilities off-balance-sheet.
Jonas Heese is the Marvin Bower Associate Professor of Business Administration at Harvard Business School.
Albert Shin is a doctoral candidate at Harvard Business School.
Charles C. Y. Wang is the Glenn and Mary Jane Creamer Associate Professor of Business Administration at Harvard Business School.
This blog post is adapted from their paper, “Variable Leases under ASC 842: First Evidence on Properties and Consequences?” available on SSRN.