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At the heart of Tango’s Road to Lease Accounting Compliance is the need to rearchitect the people, processes and technology used to manage leases to achieve initial compliance and operationalize ongoing compliance.
A new lease follows a certain lifecycle, a long and twisted path from inception to termination which varies greatly based on decisions made along the way by both the lessee and the lessor. The path by which leases travel are processes – negotiation, execution, payment, renewal, amendment, adjustments, and on and on. Leases have a path, or web of processes, that you follow today to administer and account for leases. Well, the bulldozers are here in the form of new regulations which will cause all organizations to lay a new path for leases. This new path, or set of lease processes, will travel into new departments, potentially to third-party providers outside the four walls and back. It will take right and left turns into uncharted territory. The key here is to chart the path ahead of time, so you won’t get lost or hit a lease accounting dead end.
The number of process changes are too numerous to list here. Instead, we’ve focused on the high impact ones you will want to dedicate extra time understanding and designing.
Lease Governance Process
FASB and IFRS originally focused on a “convergence project”, but when the dust settled, material differences emerged which have led to complications for global companies (‘Day One’ accounting is similar but ‘Day Two’ diverges). If you’re a global corporation with leases in multiple countries some of your leases will be governed by IFRS and others by FASB.
The main difference relates to fact that IFRS uses a single lease accounting model as all leases are categorized as financing arrangements from an income statement perspective, while FASB still utilizes a duel-model classifying leases as operating or finance. These differences impact
expense patterns and asset balances under the two systems. On the expense side, FASB ASC 842 utilizes a straight-line approach while IFRS 16 accounts for much of the expense upfront, thus their respective expense patterns behave differently. Additionally, right-of-use (ROU) asset balances will vary based on region reported. The table that follows, from Cushman & Wakefield, summarizes key FASB ASC 842 and IFRS 16 differences.
Based on the differences outlined above, multinationals will need to revisit and adjust current lease accounting processes to adhere to these new regulations. These complexities will also introduce compliance risk requiring companies to institute controls and measures to ensure data accuracy.
Lease Identification and Classification Process
The definition of a lease has changed with the new regulations and one of the biggest challenges facing companies is the assessment of all contracts to determine if they should be classified as leases under the new rules – whether that be a real estate lease, equipment lease or an embedded lease. For most organizations, real estate leases are more material, likely to be centrally managed in a software system and are fewer in number. Equipment leases, on the other hand, are greater in number, typically lack a centralized database and are often executed and managed at the subsidiary, department, local office or plant level. ‘Embedded’ leases, which exists if there’s an explicit or implicit asset in the contract and the customer controls use of the asset, are even more difficult to identify as they are often buried in agreements and determining their classification requires deeper interpretation expertise.
To meet the new requirements today, and in the future, companies will need to establish centralized enterprise-wide processes to assess contracts after they are executed and classify lease or non-lease contracts, as well as type of lease. More proactive organizations will assess leases prior to execution to architect lease conditions that optimize financial impacts by manipulating term, options, taxes, and other factors.
Lease Negotiation Process
According to a recent CFO Magazine article, “The new accounting rules may affect how companies approach new leases, and may prompt them to renegotiate some existing leases. Executives may want to more critically analyze lease-versus-buy decisions, and perhaps negotiate different terms and conditions in lease agreements to manage the impact of the new rules.” Moving to a standardized way of negotiating leases will be a difficult task for most, especially for real estate deal makers who are often more art than science. Defining the circumstances when lease-vs-buy models are employed, incorporating more sophisticated discounted cash flow analyses and instituting strategic checkpoints such as equipment obsolescence risk or alternative minimum tax considerations are a few best practices.
The level to which Procurement Departments are involved in contract negotiations varies substantially by size of company and type of contract. Larger organizations tend to have robust procurement functions and processes, while smaller companies often lack a procurement group and rely on decentralized or department level procurement of products and services. Additionally, many large organizations with well-established procurement groups do not engage procurement for real estate leases, design and construction services or the procurement of furniture, fixtures and equipment (FF&E).
All of this should change as companies begin to comply with the new lease accounting standards. A standardized procurement process is the perfect place to utilize new lease identification and classification tests to ensure leases are not slipping through the cracks. It also presents an opportunity to deploy deeper lease vs. buy analysis and other lease optimization tactics. Again, many companies will face headwinds trying to insert standardized procurement processes into the real estate deal making process.
Accounts Payable & Accounts Receivable Process
We’ve acknowledged several times that real estate leases tend to be managed centrally by a lease administration group and a purpose-built lease software system and database. The same cannot be said for equipment and embedded leases that often live at the department level in Excel spreadsheets and file cabinets. The call to action of the new lease accounting standard is clear – all leases should be managed in a centralized, purpose-built software solution.
Moving to a single system to manage all leases will necessarily impact both the accounts payable and accounts receivable functions for all lessees. Specifically, equipment leases, and to a degree embedded leases, will move to a process like that of real estate leases, where the software calculates payment obligations and communicates fixed and variable payments for a particular period to a company’s financial system for payment (i.e. accounts payable) via integration. Today, equipment leases are not typically managed in a system and accounts payable simply pays monthly invoices as received. Moving forward, the lease administration and accounting system will take over ownership of payment calculation and approval, while accounts payable will merely cut checks.
To a smaller degree, the same can be said for the accounts receivable process for those companies who are typically a lessee but find themselves in the role of the lessor in the context of subleases. Here again, the lease administration and accounting software calculates the pass through rent and variable expenses that will be invoiced to the subtenant and transmits on a period basis to accounts receivable, via integration, who in turn issue invoices. In some cases, this may also occur with the subletting of equipment.
Lease Event Process
A lease event includes any time a modification to a lease occurs, such as whether to exercise a renewal or purchase option, at which point the lessee must reconsider certain assumptions made at the lease commencement date. At the time of a modification the lessee must remeasure the lease liability and adjust the underlying right-of-use asset. An updated discount rate must also be applied, except in special circumstances.
So, what does all that mean? It means your process will need to change whenever, according to the ASC 842 Glossary, “a change to the terms and conditions of a contract that results in a change in scope of or the consideration for a lease.” Examples include lease renewals, amendments, renegotiations, early terminations and change in timing of payment, to name a few. To catch all lease events that require lease modifications, and therefore remeasurement, companies will need to insert process controls to trigger the assessment of a change as defined by the new regulations. This will not be an easy task given the nearly limitless changes that can happen to any given lease.
To be clear, the new lease accounting standards will not materially impact U.S. federal taxes. Instead, tax functions will likely benefit from the newly available data for all leases – such as renewal options, lease terms, payment schedules, etc. – that will be required to facilitate the new lease accounting calculations. According to PwC, “tax departments may identify necessary changes, or more optimal methods, related to their historical tax treatment of leases and related items. A tax change in method of accounting may be available to provide more appropriate or benefited tax reporting prospectively for leases. Specifically, tax departments may need to review the following U.S. tax accounting method items in conjunction with the adoption of the new leasing standard:
- Characterization of leases (i.e., sale, lease, or financing)
- Timing of income or expense under IRC Section 467
- Treatment of tenant improvement allowances
- Treatment of lease acquisition costs
For tax departments, during the adoption of the new accounting model it is important to review the data repository of the organization’s entire lease portfolio, inclusive of renewal options, lease terms, payment schedules, etc. from both a financial accounting and income tax perspective. This will enable companies to effectively:
- Identify differences between the current standard and new standard,
- Inventory all existing leases and deferred income tax items associated with the leases
- Assist in the computation and reconciliation of book/tax differences
- Assess federal, state, and international tax impacts
- Implement a process to properly characterize a lease transaction under the new standard on a go forward basis, while at the same time assessing the tax treatment of each lease transaction.
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