With the new Financial Accounting Standards Board (FASB) lease accounting standard — Accounting Standards Update (ASU) No. 2016-02, Leases (Topic 842), many companies are grappling with the transition mechanics and discovering their current systems to track and manage leases are simply inadequate for handling the massive amount of additional recordkeeping and accounting work that will be required.
The provisions of Topic 842 are intended to give financial statement users more transparency by requiring operating leases to be shown on the balance sheet rather than mentioned only in footnotes. Except for certain narrowly defined short-term leases, U.S. GAAP now will require that all leases be recognized on a lessee’s balance sheet as a lease liability with a corresponding right-of-use (ROU) asset.
For public companies, not-for-profit entities that have issued securities that are traded on an exchange, and employee benefit plans that file with the SEC, the new standard goes into effect for annual periods beginning after Dec. 15, 2018. For all other entities, the standard is effective for annual periods beginning after Dec. 15, 2019, and interim periods after Dec. 15, 2020.
As they prepare for these deadlines, perceptive finance officers are recognizing the need to centralize and integrate their previously disconnected lease management practices, and they are using the issuance of Topic 842 as an opportunity to upgrade and automate potentially outdated manual processes.
A challenging transition
Like many FASB ASUs, the lease accounting standard will require companies to adopt new policies in order to ensure their financial statements are in compliance with U.S. GAAP. Similar to what many companies experienced with the implementation of Topic 606, Revenue From Contracts With Customers, in order to implement the new lease standard, companies may also need to make major changes to their accounting processes and practices.
Given the requirement to present leases on the balance sheet, the process of identifying contracts that are or contain leases takes on a greater importance. In addition, while the income statement profile of leases remains largely unchanged, the requirement to present operating leases on balance sheets also introduces new accounting complexities (e.g., impairment testing).
Many companies will not want to clutter their general ledger with detailed accounting entries for each lease. As a result, they may find it necessary to maintain a lease accounting subledger to record all relevant journal entries. This might result in the need to maintain three separate schedules for every lease they enter into:
- A payment schedule, which includes discounting of future lease payments.
- A depreciation schedule for the ROU asset, which includes the new computation for the reduction in value of the ROU asset for operating leases.
- A liability amortization schedule, which includes the interest accretion on the lease liability.
Companies will need to update those three schedules every time a lease is modified, such as from changes in rates or terms, extensions, renewals, or impairments. This level of detail and complexity, combined with the volume of leases to be tracked, version control needs, and workflow approval requirements, may make it difficult for many companies to continue managing their lease portfolios using spreadsheets, as many companies still do.
First step: Lease inventory
Before companies can begin estimating the cost and effort involved in the transition to the new standard, they first will need to compile an accurate inventory of all their leases. While that might seem like a relatively straightforward process, some companies have found it more difficult than expected to accumulate all the information necessary to make that determination.
In some businesses, lease management is highly decentralized. Individual business units — and often individual locations — are accustomed to managing leases locally. Because leases can be embedded in contracts that, in form, may not appear to be a lease, a good indicator of how at-risk a company is for having leases go unnoticed is the number of individuals with authority to enter into a contract.
For example, business machine service contracts may include embedded leases, in addition to their provisions for ongoing maintenance, supplies, and service. Embedded leases may be found in a broad array of locally purchased business services and devices, in contracts for items ranging from computer servers and ATMs to vending machines and beverage dispensers. Local managers may regard such agreements as service contracts when they may, in fact, contain leases for accounting purposes.
While the new lease standard allows organizations to elect not to reassess whether existing contracts are or contain leases at transition, this practical expedient does not apply to incorrect or missing assessment under legacy GAAP. As a result, companies will need to have a process — both at transition and on an ongoing basis — for identifying whether its contracts are or contain leases.
This task raises numerous questions: Can managers be trained to recognize which of the many contracts they manage actually are leases that need to be communicated to the accounting department? Who will handle this training and how? Who will compile the documentation that will be needed to record the many specific terms and data points that must be tracked for every lease?
Existing resource demands on accounting departments may make it impractical to handle this initial compilation internally, so many companies are turning to consulting organizations and outside vendors to assist with the implementation.
Technology may also be able to help. Artificial intelligence (AI) applications are capable of scanning thousands of documents to recognize common lease clauses, contract management software can serve as a central document repository, and lease accounting software can automate the creation of necessary lease schedules and journal entries. Such capabilities reduce the risk of an incomplete lease inventory and — by reducing demands on human resources — may help pay for themselves.
Centralizing lease administration
For organizations with more than a handful of leases, a decentralized, locally managed approach to lease administration may need to mature into a more centralized and standardized model in order to apply — in a controlled fashion — the new lease accounting requirements. At the same time, though, most local and business unit managers still will need the autonomy and flexibility to negotiate and enter into routine contracts, including those that might contain embedded leases.
To address this situation, businesses can take one of two approaches: They can spend the time and effort needed to educate all managers who have contract authority about the scope of the lease accounting standard, the various types of lease contracts that could be encountered, and the specific data points that must be reported to the accounting department. Or they can issue a blanket requirement that all contracts entered into must be reported to the centralized accounting function, which will be responsible for determining whether they contain lease provisions.
Technological tools can help
For a very small business that leases office space, a few copiers, and a company car, maintaining the required lease information on spreadsheets still might be feasible, at least theoretically. But even such a small lease portfolio would require constant monitoring and manual updating — with all the opportunities for error that provides. In reality, even many small businesses are at the point where they have determined that dedicated contract management or lease administration software is a necessity.
For most midsize or larger companies, which often engage in hundreds or even thousands of individual leases, standardized contract management processes may already be embedded in their enterprise resource planning (ERP) systems or other enterprise-level software. Yet accounting departments are likely to find these existing systems do not record and report some of the detailed lease information the new standard requires. The accounting department is likely to be overwhelmed by the volume of hands-on work needed to consolidate the necessary information from different sources.
In the longer term, companies will need to implement consistent, repeatable processes that update the accounting organization whenever any lease changes occur. To achieve this, most companies will require both lease administration and lease accounting capabilities.
Making the right technology choice
Companies that already have contract management or lease administration software in place will need to decide whether these day-to-day management systems also are capable of managing all the accounting-related data, calculations, and reporting that will now be required, or whether they are better off installing a stand-alone system for the accounting calculations. Each approach has pros and cons.
Embedding the new lease accounting requirements into an existing system offers many obvious benefits, enabling companies to take advantage of investments they have already made in ERP or other systems. The chart of accounts, user restrictions, approval workflows, currency setups, and numerous other parameters already are established. In addition, users will be familiar with the interface, which can reduce risk and save training time and costs.
On the other hand, many large organizations have multiple ERP systems in various business units, so looking for nonintegrated lease accounting software may make sense. However, the additional implementation and integration costs of nonintegrated lease accounting software can be high, and these costs, in addition to the strain on the IT department, need to be considered when making decisions about adding software.
Regardless of the path the company chooses, real-time integration between the administration and accounting processes is critical. Many everyday events that occur over the life of a lease will trigger revisions to one or more of the leasing subledger schedules. These include changes in terms, the exercise of various options, renewals, buyouts, and numerous other modifications that must be tracked. In a large organization with hundreds of leases, dozens or even hundreds of such events could occur every month.
Other technology considerations
In the past, reading and extracting contract terms was done solely by humans. Today, a number of new technologies use the natural language processing branch of AI to create models that can read, and therefore extract, lease contract terms. These systems generate a confidence score on the accuracy of the reading. For example, a company may set a policy requiring those contracts that fall below an accuracy reading of 98% to undergo human review. While this is a promising technology, companies may find it to be cost prohibitive for portfolios with fewer than a thousand leases.
When selecting a lease accounting software solution, companies should consider a number of factors. Lease accounting software has been around for some time, and established vendors have built up a lot of knowledge over the years. Older software that has been field-tested in the real world can offer advantages. On the other hand, some new vendors have emerged in response to, and are specifically built around, the new standard, and their products might offer more effective solutions to assist companies with their implementation efforts and accounting needs.
Flexibility, scalability, and web-based access are essential in any software selection. Buyers should be sure their lease accounting software’s application programming interfaces integrate well with other accounting systems. In addition, buyers also should confirm that system providers will continually ensure validity of the system’s calculations and monitor any amendments issued by standard-setters that might necessitate software updates.
Companies with international operations may also need their systems to comply with IFRS 16, Leases, which differs from U.S. GAAP in various ways. For example, IFRS 16 classifies all leases as finance leases, whereas Topic 842 retains a dual-classification approach.
Ideally, finance officers will regard the transition to the new lease accounting standard as an opportunity as well as a challenge. If they discover their current lease accounting processes and systems are inadequate for handling the new requirements, they can centralize, upgrade, integrate, and automate their outdated systems to further strengthen their finance function.
— Simon Little, CPA, is a senior manager in risk consulting; Luis Lopez Garay, CPA, is a performance consulting senior staff member; and William Watts is a principal in risk consulting at Crowe LLP. To comment on this article or to suggest an idea for another article, contact Ken Tysiac, the JofA’s editorial director, at Kenneth.Tysiac@aicpa-cima.com.