Last Updated on March 23, 2023 by Morgan Beard
The Financial Accounting Standards Boards outlines lease accounting policies and controls that are built to ease the transition to new lease accounting standard, ASC 842. Most public and private companies have already transitioned, but, post-audit presents the perfect time to add policies and controls to your lease accounting process. After all, your finance team is undergoing major changes in tracking and managing leased assets. So, it’s a good time to implement new and effective policies and procedures. It’s also crucial for your company’s financial health.
That’s because the new standards introduce changes that fundamentally impact your balance sheet. Your team is now required to record all leases as assets and liabilities on the balance sheet, meaning you must have a centralized and accurate accounting process. Failure to get it right could have a significant effect on your company’s bottom line.
At the same time, the guidance from ASC 842 and IFRS 16 offers several options for your lease accounting process. In fact, on February 15, 2023, FASB met and released their Tentative Board Decisions Common Control Arrangements to assist in your election of particular policies and controls. Many of these options can also have long-lasting effects. Only well-defined policies and controls ensure things are done by the book without negatively affecting your financial statements. Auditors love seeing well-documented procedures because these processes illustrate why you chose certain guidance and help the auditor understand those choices.
So, how do you choose the right controls for your new lease accounting process?
Building Your Lease Accounting Process Team
When you begin updating your policies and controls, you might be a bit surprised by the scope of the undertaking — it’s a rather large project involving multiple departments in your company. Like any project of this size, it requires planning, allocation of resources, pre-planned timelines, and project milestones.
Identify each department and group in your business that these changes affect. In other words: identify all the groups with leases that have managers with purchasing or contracting authority. As you make your list, you’ll likely find most departments have leases and this type of authority:
- If your company manufactures products, you are likely to lease production equipment.
- If your sales team has to travel, several leased vehicles are probably attributed to the business.
- Your IT department might lease servers and network equipment.
These individuals need to understand how leases now fit into and affect the company’s bottom line, so create a small team. This team plays a part in making sure your lease controls are effective and accurate with the Accounting Standards Codification accounting principals.
Choose representatives from each group to serve as ambassadors. They’ll offer insights from their departments and help others to learn the new lease accounting policies and controls to use going forward.
And of course, the final milestone for your project will be the full implementation of new controls, policies, and procedures for your company’s lease accounting process. A lot of discussion and decision-making happens between the first milestone and the last. Here’s a look at some things to consider.
Centralize Your Lease Information
If teams are to work together on lease controls, all lease data should be in a central location. With information spread across multiple sources, it can be difficult to know what’s accurate and what isn’t.
Centralizing lease data is a goal because it records all decisions and changes made for auditors to review later. And lease accounting standards like ASC 842 and IFRS 16 encourage the practice of centralizing lease data.
The easiest way to do this is with a lease management platform. These software systems are designed from the ground up to centralize all lease data and management tasks. If you don’t currently have modern lease management software, your team’s first task is to review options and choose a system.
When all leased assets are managed in the same system, it’s easier to schedule payments, create journal entries, track lease history and prepare financial statement line items. It’s also much easier to enforce policies and controls within software.
ASC 842 Survival Kit
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Develop Your Policies
The transition to ASC 842 or IFRS 16 is an ideal time to take a look at your existing policies around lease management. If you’ve been through a transition or are in the process right now, there is policy guidance built into the standards, starting with transition methods.
ASC 842 requires companies to transition following one of two different transition methods because it requires an equity adjustment that reflects the impact of adopting the standard.
Your transition method options under ASC 842 include:
- The Effective Method: Applies the new standard as of the effective data, with any comparative periods still following ASC 840 standards.
- The Comparative Method: Applies the new standard as of the earliest comparative period.
ASC 842 also allows some practical expedients to reduce the burden of adopting the new standard. The options include:
- By lease
- By asset class
- By accounting policy elections
Adequately document the policy choice(s) and their application.
The accounting rules outline that lessees have the option to make an accounting policy election not to recognize the right-of-use (ROU) asset and lease liabilities on short term leases. A short lease term is defined as a lease that has a term of 12 months or fewer at the time of commencement, without an option to purchase the leased asset that the lessee reasonably expects to exercise. If you were to make this election, it must be done at the asset class level.
Another ASC 842 policy decision is if you develop a materiality threshold, not all lease assets and liabilities are recognized before transitioning. The idea here is not recognizing some lower-value leases during transition can save time and resources. But an important consideration is that your lease materiality threshold should be similar to your asset capitalization threshold.
Wherever you set your materiality threshold, your team’s rationale needs to be documented in your ASC 842 policy memo.
Understanding Your Lease Portfolio
As you centralize your lease data, your team should be gathering an understanding of your lease portfolio.
Although it may seem like a basic step, you’ll want to make sure everyone on the team understands the definition of a lease. A shared understanding of leases will help guide decisions like whether or not to capitalize on short-term leases and the election of practical expedients which will impact your required accounting entries.
Create documentation of judgments and assumptions that go into creating policies for your lease portfolio. Decisions you make regarding lease renewals, purchase options, and how and when to terminate lease agreements should all be set as policy. ASC 842 guidance specifically mentions reviewing the implications of lease options. You will want to document the factors considered and the rationale for your team’s decisions. This can exclude external factors like current market conditions, the expense of choosing lease options, and other considerations.
The phrase “reasonably certain” is often used in lease standard guidance. But what qualifies as “reasonably certain” is open to interpretation. For example, are you reasonably certain to exercise your option to purchase the underlying asset. How you and your team choose to see it should also be documented as internal controls. It should be a high standard, based on factors like your company’s history and current market conditions.
If you’re already starting with some effective controls and policies in place regarding renewals and purchase options, you’ll be a step ahead. That will give you a baseline to work with, but the team should evaluate any existing policies for their impact on financial statements like your income statement, balance sheet, and P&L statement. In any case, your portfolio should have policies for renewing leases and exercising purchase options and legally enforceable terms on your lease agreements. Financial institutions, auditors, and Certified Public Accountants will use these lease accounting policies and procedures to audit your company’s balance sheet under the new requirements.
Asset Classes vs. Risk and Use
Some of the elections you choose to turn into policy can be applied at an asset class level. However, how you determine asset classes should also be clearly defined. Asset characteristics help define classifications, such as equipment, vehicles, real estate, and the like.
The other option is to classify assets based on their risk and use. In this case, you wouldn’t classify a building as simply “real estate.” Instead, you would make classifications based on the type of building—warehouse, manufacturing site, office space, multi-use, retail and so on.
Lease and Non-Lease Components
Lease components outline the lessee’s right-of-use asset and lease obligations over the remaining lease term. Non-lease components are associated with the right-of-use asset yet are not critical to use of that asset. One example of this is CAM, common area maintenance of your space. Exercising this practical expedient as outlined by the generally accepted accounting principles means that the lessee chooses not to separate nonlease components from lease components. And instead account for those lease components as a single component.
Forming Your Procedures
Auditors will look to understand the decisions you and your team have turned into policy to mitigate financial risks. This is where your processes and procedures come into play.
In particular, you’ll need to have procedures for capturing your operating lease liabilities, operating lease ROU assets as well as your finance lease liabilities and finance lease ROU assets. External auditors will take a magnifying glass to your lease accounting policies and controls.
Ensuring that all leases are captured is one of the main reasons your team has representatives from multiple departments. Finance teams may be disconnected from other groups like real estate, facilities and operations — groups in a company that might have equipment contracts that qualify as leases. Start by asking all departments for a list of leased equipment and other contracts, along with their ongoing payments.
The team should then compare the list of equipment against existing contracts. Make sure each has a match. If you have equipment without a contract, or vice versa, that’s a sure sign that not all leasing arrangements are captured.
Auditors will need to understand the procedures used to assess the accuracy of your lease portfolio. This is where some thorough procedures can show the due diligence you’ve done, and will continue to do going forward. Start by documenting your procedure of comparing recurring payments to the expenses detailed on your list of leases.
Match the lease information — asset name, serial number, location, vendor, original lease details as well as any lease modifications — for all contracts and look for any gaps. Once the listing is finalized, compare to your lease amortization schedule. Make sure the final listings match your commitment schedule.
Ensure all team members understand what a lease is, and how the new lease accounting standards impact your company. This will go a long way toward ensuring your lease portfolio is full and accurate. Going forward, you’ll have a process for identifying lease agreements and ensuring they’re correctly classified and accounted for.
Rent Expense Procedure
Rent expense should also be matched up to contracts, to find any missing data. Expenses accounted for on operating leases will result in a straight-line expense. While expenses accounted for on a finance lease will result in the lessee recognizing the interest expense and the lease amortization expense, making the expenses will be higher at the lease commencement date and decrease over time.
Extrapolate annual rent expense from a listing of leased real estate assets against the contract payment details. These amounts don’t necessarily have to reconcile exactly. As long as they’re close, you’ll have a good indication of whether rent expense was captured in the lease listing. Auditors will likely perform a similar reconciliation analysis, so making this a part of your rent expense procedure can save some surprises popping up down the road.
Documenting Your Disclosures
Financial statements have a number of required disclosures. ASC 842 and IFRS 16 each have their fair share of qualitative and quantitative disclosures that expand upon those in earlier standards.
Evaluate the completeness and accuracy of your disclosures, creating a documented procedure around your verification process. Make sure to include any new policies, procedures, and lease accounting controls that went into your disclosures so that auditors can understand your process.
Robust policies, procedures, and controls go a long way toward verifying your disclosures. Auditors will be looking for quantitative footnote disclosures as evidence for accounting purposes, so the more you can document your procedure, the better.
Occupier: The Lease Accounting Solution
When you consider the complexity of lease accounting under the new standards, it’s easy to see why it’s so important to have a full-featured lease accounting software platform. With so many critical touchpoints in the lease accounting implementation process, and ongoing compliance process, all lease data must be in a central location. Enforcing policies, procedures, and controls can be impossible to do manually, but a centralized lease management solution makes it easy to implement your controls.
Occupier offers modern solutions built on an innovative and intuitive tech stack. The entire lease accounting process is automated, ensuring compliance with the latest standards and making it easy to close the books each month. To see how Occupier can take the hassle out of lease accounting, request a demo today.
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