Lessons from Early Lease Accounting Adopters

By Dustin Osgood, Sheri Wyatt, David Shebay, Edward Tarka, PricewaterhouseCoopers for CFO.com

A recent PricewaterhouseCoopers survey found that only 1% of companies had completed adoption of the new lease accounting standard, ASC 842. The deadline is looming for public companies, which are required to apply the standard for annual reporting periods beginning after Dec. 15 of this year. (The measure takes effect for private companies one year later.)

For those still working toward that goal, in this article PwC offers some lessons learned to date from companies that have made substantial progress with their implementations.

The article also takes a look at a number of accounting challenges that companies are encountering as they move through the implementation process, and offers some thoughts on possible opportunities.

That process typically includes three phases.

Laying the groundwork for an efficient implementation might involve a survey of existing leases and business requirements, workshops to educate stakeholders, and an assessment of data completeness.

Don’t delay assessing the current landscape of your leases and available lease information. Depending on the data’s completeness and accuracy, this process could require a multi-departmental effort spanning several months.

Sixty percent of the companies we surveyed cited difficulties identifying their lease population, and it’s easy to see why. Many organizations need to collect and manage data from thousands of leases and related documents, such as amendments, schedules, and asset listings.

Frequently, companies uncover gaps: missing information about leases, missing leases held by subsidiaries, or a need to digitize leases that exist only in hard copy.

If missing data needs to be abstracted from source lease agreements, ample time and resources are needed. Manual lease abstraction is extremely time consuming and error prone, and many companies are using technology to help accelerate the process and increase accuracy.

Finally, remember that auditors will want to understand how companies reached their determinations. Therefore, a well-planned and auditable approach to gathering data and assessing completeness is essential.

This phase includes determining whether a new lease management system is needed, as well as vendor selection for any new system requirements.

With 53% of public companies and 25% of non-public companies expecting significant system changes to accommodate the new leasing standards, choosing the right lease management system is key.

The decision will be particularly time-sensitive for many companies, as 70% of public and 57% of non-public survey respondents expected to go live with system changes after the new standard’s effective date.

The number of available lease management systems has increased since the new accounting guidance was released, complicating decisions. To avoid becoming overwhelmed, some companies are considering only vendors that offer end-to-end lease management, accounting, and standardized reporting. Others are considering vendors that may offer limited functionality, rather than end-to-end lease management.

Creating a more targeted list of candidates saves precious time needed to implement a solution before the deadline.

When evaluating system needs, consider the range of potentially affected stakeholders. For example, income, property, real estate, and sales and use tax personnel may need additional data and/or functionality from the leasing system.

Unfortunately, many lease management systems are not designed to produce tax reporting. Given the overlap of data needs, we have found that some companies are considering broader system integrations to run more efficient compliance and planning functions.

In addition to system solutions, consider which processes and controls - from formal governance structures to standardized lease management across the organization - will be necessary to support compliance and ongoing operations. Defining roles and responsibilities for the new lease operating model is also crucial.

This phase includes four sub-components:

Preparation (2-3 weeks) focuses on project planning and alignment. Responsibility and accountability for each required activity should be assigned to relevant stakeholders and discussed to help build consensus.

Design and build (8-14 weeks) includes developing requirements and policies, creating key design and process design documents, building the system, and running test cases.

Sequencing is crucial. To reduce the risk of rebuilding, begin building the system after the design is completed and approved. Investing the resources needed to assemble a complete lease data set and build real-world test cases will pay significant dividends over the long run.

A key insight that applies here is that process designs may need additional controls, depending on the technology configuration and historical treatment.

Examples include how accounts payable will be transacted and reconciled, consideration as to whether historical capital leases are in the fixed asset system, and how the new deferred tax liabilities will be reconciled.

Another important insight: Depending on the implementation timeline, additional manual processes for all or part of the lease portfolio calculation may be required. Companies considering manual bridge solutions like spreadsheets will need additional controls.

Testing covers data migration, regression testing, user acceptance testing (UAT), and training. Be aware that system defects or failures may inhibit testing and extend the testing period. Thoroughly test and review accounting to determine that accurate and verifiable reports can be produced.

Stabilization focuses on go-live support:

Finance: Most existing and new leases will go on the balance sheet under the new standards. Financial reporting, budgeting, and forecasting need to be up to speed and ready for new disclosures.

Most importantly, the additional transaction processing and/or additional controls in the new system will likely require additional headcount. Many companies are looking at using an existing center of excellence or setting up a new one, and a few are using robotic process automation to help reduce headcount increases.

IT: To enable compliance with the new lease guidance, it’s vital to approach system implementations with the same rigor, discipline, and expertise as any other major IT implementation.

Tax: Accounting will change to reflect the impacts of new right-of-use asset and liability accounts.

Due to newly available lease contract data, companies are reassessing their historical tax positions and related deferred tax attributes. They’re also considering the need for tax accounting method changes to correct the treatment of leasing-related items such as the timing of rent expense.

Early coordination with the tax function will help maintain and capture data to support both tax compliance and planning, enhancing the efficiency of the adoption process. The tax classification and cross-border cash flows related to leased assets may also be impacted by new tax reform provisions, resulting in the opportunity to manage risk and increase opportunities.

The new guidelines may also affect state apportionment, transfer pricing, contracting terms, and scrutiny by tax authorities.

Procurement: The loss of off-balance-sheet financing may trigger a fresh look at lease-vs.-buy decisions. Procurement and approval policies will also need to be reassessed to help collect and standardize the lease data associated with reporting.

Treasury: The impact of debt-covenant compliance will merit consideration, especially as new debt agreements are renegotiated prior to the standard’s effective date. Additionally, the lease-vs.-buy analysis may need to be reevaluated or redesigned.

Regulatory compliance: New assets and liabilities on the balance sheet could influence regulatory calculations and, for regulated companies, necessitate increased capital reserves.

Real estate and facilities: If the new rules cause purchases to increase and leases to decrease, changes may be needed to the existing asset lifecycle management process.

A few adoption areas are proving particularly demanding from an accounting perspective. By gathering and analyzing sufficient details regarding their leases, companies can overcome these challenges and reach an appropriate answer for financial reporting.

Lease identification: A company will need to consider arrangements not typically thought of as leases, including outsourced warehousing, data management, or supply arrangements. These may be subject to the new guidance and therefore require capitalization. Determining whether an arrangement is a lease may require detailed analysis and judgment.

Incremental borrowing rate (IBR): Companies will most often use the IBR to calculate their lease liability. The new guidance requires that the IBR reflect a fully collateralized obligation, over a term similar to the lease, and in a similar economic environment.

n assessment of a company’s specific facts and circumstances will be necessary to determine the appropriate rate.

Payments: Determining the amount of the lease liability will require judgment about whether to include renewal periods or consider purchase and termination options.

Companies will also need to obtain additional data about lease payments, including which are fixed and which are variable, to determine whether they should be included in the lease liability.

Finally, depending on a company’s elections, allocation between lease and non-lease payments may be necessary.

Policy elections: The Financial Accounting Standards Board has allowed companies to make certain elections that may ease both transition and subsequent application. For example:

Some expedients must be elected as a package, and companies will need to broadly consider the impact of the available elections.

Revised and expanded disclosure requirements: The new rules call for extensive quantitative and qualitative disclosures to increase transparency related to revenues and expenses recognized, and expected to be recognized, from existing contracts.

These disclosures encompass significant judgments made by management. Companies will want to consider how to gather the necessary information and how to appropriately communicate with relevant stakeholders.

Looking beyond the lease accounting challenges, important opportunities exist, particularly in the areas of standardization, centralization, and automation.

For example, procurement departments may become more directly involved in negotiating enterprise-wide lease terms. And centralized lease data opens the door to analyzing lessor terms and conditions, enabling consistency.

Many companies stand to gain from reducing or eliminating cost leakage due to expired leases. A centralized lease procurement function in the form of a separate legal entity may be a source of tax-planning opportunities and potential pitfalls that should be considered early in the process.

Lease-vs.-buy models can also be fine-tuned to perform better. By incorporating controls and defining the circumstances in which that model is deployed, companies can optimize tax impacts. Additionally, revised tax rates and full expensing after tax reform can also lead to cost savings.

Finally, companies should consider tax-planning opportunities related to state sales and income tax, as well as “foreign-derived intangible income.”