The main driver behind the FASB’s issuance of the new lease standard (Topic 842) is to increase transparency within organizations regarding their leasing arrangements. Under the current guidance, a look at an entity’s balance sheet does not provide a clear picture of all leasing transactions and the obligations related to operating leases.
With the implementation of Topic 842, lessee organizations must recognize a right-of-use asset and liability arising from its operating lease arrangements. This change provides a more accurate depiction of a lessee’s indebtedness. From a lessor’s perspective, although the accounting for leases will not fundamentally change, the definition of a lease has been altered and there might be an indirect impact to lessors as lessees react to the lease accounting changes.
Although Topic 842 is an improvement to financial reporting, especially in regard to transparency, the impact on both lessees and lessors brings about new complexities and challenges in both reporting and operations. As companies navigate implementation, it is essential that management recognize the risks of fraud inherent in these changes.
Implementation of the standard will increase leverage on a lessee’s balance sheet, and in turn, may negatively impact balance sheet ratios and debt covenants. Financial performance-based incentives or bonuses may also be negatively impacted by bringing operating leases onto the balance sheet. The pressure to maintain healthy debt ratios, comply with covenants, or ensure performance metrics are met, can lead to an increased risk of fraud.
The time and effort that is required to both implement the standard and maintain the records and knowledge of all leasing arrangements going forward, on both the lessee and lessor sides, can be significant. These changes may also require personnel from various areas of an organization outside of accounting to assist in determining the proper treatment of lease transactions. Complexities in implementation inherently lead to additional risks. Those responsible for implementation may lean on significant judgments or estimates to try to reduce the time commitment needed to review a large volume of lease documentation. A lack of understanding of the detailed guidance can also lead to a risk that implementation is not done properly, or certain guidelines are not followed appropriately and therefore reporting of leases may be misleading.
How can organizations mitigate these risks? A strong internal control environment will assist in preventing and detecting fraud. Organizations will need to implement new key controls or modify current controls surrounding lease accounting, gathering and retention of documentation, and review and approval policies. Organizations should also ensure that the appropriate technology and software are in place to ensure proper accounting and reduce the level of risk inherent in manual transaction processing and accounting.
Organizations need to find a suitable solution for calculating the FASB ASC Topic 842 right-of-use assets and lease liabilities at the transition date and the subsequent lease accounting. Generally, an Excel-based solution would be appropriate for a noncomplex portfolio of 10 or fewer leases. If the lease profile is more complex or greater than 10 individual leases, management is better served by a lease software solution, such as simpLEASE. In addition to offering our clients simpLEASE, Schneider Downs provides advisory services for the technical aspects of lease accounting. For more information concerning lease accounting and the impact on your organization, please visit the Schneider Downs Our Thoughts On blog or email us at [email protected].
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Material discussed is meant for informational purposes only, and it is not to be construed as investment, tax, or legal advice. Please note that individual situations can vary. Therefore, this information should be relied upon when coordinated with individual professional advice.