Remember Enron? Its executives used various accounting “tricks" to hide liabilities. And after the company failed, the SEC started to investigate off-balance-sheet financings. They found a giant loophole in the regulations that exposed investors to significant risk from operating leases.
The debacle prompted the SEC to make lease obligations more visible in financial reports and provide greater visibility into a firm's debts. Since then, both the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) have been working to introduce new lease accounting standards that promote greater transparency. To that effect, the FASB and IASB have developed Accounting Standards Codification 842 and IFRS 16, respectively, which provide the requirements of financial accounting and reporting for lessees and lessors. These standards take effect beginning January 1, 2019.
The standards require all leases longer than 12 months to be capitalized and reported on the lessee's balance sheet. The result: lease payments will become a lump-sum liability, which means debt ratios will go up and impact bank covenants. While this delivers the greater visibility required, it also increases audit scrutiny.
Will your organization be affected? If you have a large lease obligation, especially a real estate or equipment lease, then the answer is yes. The challenge we've seen is that most organizations do not have the contracts, data, systems, or processes in place to comply with the new standards.
Research by our partner LeaseAccelerator has found that many Fortune 500 companies have grossly underestimated the number of equipment leases they hold. They don't have a mechanism to track these leases. Their ERPs do not capture lease details or maintain the link between assets and liabilities — and many rely on spreadsheets that sit in systems and files around the world. All of which means most companies do not have access to the details and information that regulators now want.
So how can you prepare for the new lease accounting standards? We have five practices that you can adopt to comply with the new reporting standards.
- Define the strategy: Start by documenting a lease operations strategy. Clarify how your business decides whether to buy or lease, and specify when and how to perform lease reporting and analysis. Once the strategy is in place, share it with the company's stakeholders.
- Design the processes: Next, identify the key leasing operations processes. Create a framework by identifying the who, what, when, where, why and how, and be clear about your objectives. In addition, identify the risks in your leasing operations and document the policies to control each risk.
- Figure out the technology: Simplify and automate processes wherever possible to reduce the administrative burden of complying with the regulations. Web-based workflow automation, document management, transaction processing, and lease accounting software are key technologies to consider.
- Hire the right talent: Get experienced leasing professionals to manage your processes. It's important to assign individual people as owners of specific processes. They should be responsible and accountable for negotiating lease agreements, analyzing transactions, managing the health of the lease portfolio, and ensuring compliance with lease accounting and reporting requirements.
- Adopt shared services: Standardize your leasing operations, and consider managing them through a shared service. This will compensate for any geographic or regulatory differences, while keeping control on lease budgets and asset movements. And you will also be able to build on your employees' expertise and achieve economies of scale in managing your lease portfolio.
Getting leasing right will bring you strategic financial and competitive benefits. Your business will:
- Have access to the reliable data needed for accurate and complete financial reports, which lessens your compliance risk
- Make better use of cash flow and offer more budget flexibility
- Be armed with the latest leasing technologies — and your business will get a productivity boost as employees with have more time for higher value activities
- Save up to 17% in annual leasing costs
With the new lease accounting standards come significant compliance risks. While there's a lot to do to get ready, following our five best practices will help you stay compliant, improve leasing operations, and also reduce costs. And most importantly, you'll have peace of mind knowing that the next Enron isn't going to happen on your watch.