Growth Companies

Lease Accounting Post-Adoption

Many companies used brute force to meet the initial lease accounting deadlines. To comply long term, they will need processes, policies, and controls.

It has been just over six months since the initial deadlines for the new lease accounting standards went into effect. In the first 180 days, approximately 400 of the S&P 500 filed an interim statement (Form 10-Q). The result has been a transfer of more than half a trillion dollars’ worth of operating lease liabilities onto corporate balance sheets. This “dark capex” has been buried in the footnotes of financial disclosures for the past four decades, but these assets and liabilities are now being featured under the bright lights of the balance sheet.

With the first wave of disclosures under ASC 842 completed, the hardest part of the transition would appear to be complete. Not so fast. Most of the opening balances reported in the first 10-Qs were only arrived at through the use of brute force, spreadsheets, and armies of consultants working feverishly to meet the reporting deadlines.

Although companies purchased lease accounting software applications to automate much of the heavy lifting for ASC 842, few of these packages were fully functional by the deadline. As a result, many companies relied on workarounds and 1960s-era manual processing to produce the necessary disclosures.

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Over the coming months, these companies will need to transition to longer-term, sustainable strategies for compliance. They will need to institutionalize processes, policies, and controls for leasing that leverage automation and systems. They will need to perfect the close process to reduce the risk of earnings announcement delays. And they will need to bulletproof the record-to-report lifecycle to reduce the risk of a material weakness from their first post-implementation audit.

Centers of Excellence

One of the biggest post-adoption challenges for companies will be in the areas of talent, staffing, and training. Companies will need to transition away from the original project team that was used for implementation towards a longer-term staffing strategy with in-house personnel.

The best practice most larger companies are following is to build a leasing center of excellence, which will develop deep expertise in the new standards and own the record-to-report process. These new leasing COEs are typically being co-located with shared service centers for payables, collections, and fixed asset accounting.

“Unlike other accounting disciplines, such as fixed assets or revenue recognition, leasing has never been a focal point for finance. So, there are few experienced hires to recruit from other companies.”

Unfortunately, staffing a leasing COE won’t be as easy as building other shared service centers, because there is a significant shortage of leasing talent in the market. Unlike other accounting disciplines, such as fixed assets or revenue recognition, leasing has never been a focal point for finance. So, there are few experienced hires to recruit from other companies. And there are no recent university graduates trained in leasing. As a result, companies will need to invest significantly in training programs to quickly build the necessary technical accounting expertise.

Once operational, COEs will need to perfect the monthly close and quarterly disclosure processes to ensure that earnings announcement dates are not delayed due to complications with the new leasing procedures. Teams will need to identify timelines for performing sub-ledger cutoff and updating foreign exchange rates. They will need to establish reconciliation processes between the leasing sub-ledger and the accounts payable and general ledger. And they will need replicable processes for generating the quantitative and qualitative disclosures required by ASC 842, such as the weighted average discount rate and weighted average remaining lease term.

Processes, Policies, and Controls

To ensure the accuracy of the accounting and the completeness of the lease population, businesses will need to track all of these changes to the lease portfolio. This is where the greatest challenge lies. Unlike other balance sheet line items such as payables, receivables, inventory, and fixed assets, there has historically been little consistency and automation of the leasing processes across the business. As a result, accounting groups will need to drive these changes across the enterprise.

New Leases. Companies will need to institute processes, policies, and controls to track new contracts being signed. These include not only contracts with the word “lease” at the top of them but also outsourcing and service agreements that may have embedded lease assets. Companies will also need to monitor for new sub-leases and sale/leaseback transactions, which could be common in real estate portfolios.

Changes to Leases. Companies will need to institute processes, policies, and controls to track changes to leases that might impact the accounting. Variable rents tied to business performance (think sales), inflation indices (think CPI), or interest rates (think LIBOR/SOFR) will need to be tracked. Additionally, accounting teams will need to track contract changes that might impact the number of equipment assets on a lease or the amount of floor space being rented. New processes will need to be established to track changes to business plans that might impact the reasonably certain holding period for leases. And, finally, companies will need to monitor their portfolios for leasehold improvements, potential impairments, and sublease extensions that might impact the accounting.

Expiring Leases. Companies will also need to institute processes, policies, and controls to track end-of-lease decisions and contract changes. The end of an equipment lease can have a handful of potential outcomes. The equipment could be returned. The equipment could be purchased. The equipment lease could be renewed with different rent and contract terms. Real estate leases, on the other hand, could be terminated or renewed. If renewed, not only might the rent change, but the amount of floor space being leased could expand or contract.

Automation through lease administration and lease accounting systems will be a critical success factor for companies with large lease portfolios. Suppose a business has a portfolio of 1,000 leases with an average lease term of four years. On average, 250 of the leases will expire in any given year. Assuming that the leased assets on the expiring schedules are critical to the business, the business will need to sign another 250 new leases to replace the assets. The result is approximately 500 contract events each year that need to be reviewed for accounting impacts. Suppose another 250 of the 1,000 leases have annual rent adjustments or some middle-of-term contractual change. The result is potential accounting changes to 75% of the lease portfolio in any given year.

Enterprise Governance

At many companies, leasing has been a maverick purchasing mechanism. Leases were used as an alternative to purchases to navigate around annual budgeting restrictions or to circumvent capital expenditure processes. With operating leases now on the balance sheet, organizations are applying many of the policies and controls in place for fixed assets to leasing as well.

Controls. Many companies are instituting new financial controls for leases to ensure that the accounting is accurate. For example, most organizations require formal asset requisitions for all new leases. Others are going one step further, requiring that the treasury department perform lease-versus-buy analyses to ensure the best use of capital. Another popular control being instituted is to require all contracts be reviewed by accounting prior to signature. Contract reviews help to ensure that accounting has visibility into the complete population of leases.

Budgeting, Planning, and Forecasting. With leasing data centralized into a single system, the financial planning and analysis (FP&A) team can perform more accurate budgeting, planning, and forecasting for upcoming years. Additionally, the FP&A team can run more detailed reporting on the lease portfolio. Think profit and loss analysis reports by business unit, geography, or leased asset type.  FP&A can also analyze the economics of the lease portfolio by comparing the actual present value at the end of a lease to the original present value expected at commencement.

Spend Analysis. With leasing data centralized into a single system, the procurement team can now have visibility into the spending patterns related to leasing. There may be potential cost-saving opportunities for the business by negotiating leases with more competitive financing rates and more favorable contract terms. Alternatively, there may be opportunities to reduce cost leakage from the business by identifying lease contracts that have automatically renewed at higher rents, which could be terminated or renegotiated with lower prices.

Companies have a large undertaking ahead and must work diligently on their transition to longer-term, sustainable strategies for success. Institutionalization of processes, policies, and controls is vital. So is an ability to perfect the close process. Moving past the workarounds and consultants, companies must push themselves to start developing controls and processes for long-term success.

Michael Keeler is the CEO and founder of LeaseAccelerator.