Lease accounting – how to make it sustainable

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IFRS 16 on leases kicked in the doors from 1 January this year. This standard gave (or should have given) some headache to most companies using IFRS, regardless of the sector or the type of reporting they are required to do. Plenty of information and great advisory materials came out on the accounting methods brought in by IFRS 16 (tip: if it does not deal with lease modification, it is just scratching the surface…), comparing the new and “old” lease accounting, shedding some light on adoption choices (full or modified retrospective) and so on. This post is not something “just another one of those”. What we want to have a deeper look at is how to actually implement IFRS 16, in particular how to make it sustainable. If your IFRS 16 project lacks any of the points we discuss below, it might be worth having a second glance at it to avoid surprises later.

Understand your current exposure

No, this is not about reading contracts with a title of “Leasing” or “Rental”. We recommend first to assess how exposed the company operations are to leases. Not a single expert from the accounting or finance team will be able to do it alone, above a certain company size. Just as with many other, complex standards, here is what we think you should do:

  • Communicate. Prepare a memo, a one-pager on the core of lease identification, tell the business units why it is important for them (after all, EBITDA will increase…). Copy legal, procurement, controlling and yes, IT, to bring them to the same page.
  • Ask. Make interviews with key business experts to be able to judge whether the way they are conducting business, receive services or perform procurement might result in actually entering into something which qualifies as a lease under IFRS 16. Remember, it is not rental contracts we are looking for, but any kind of service the fulfilment of which depends on a specified asset. Transportation, storage, IT services are potential candidates of embedded leases.
  • Analyse. Make your homework on reviewing OPEX subledger, asset lists, revenue components and assess whether they contain items pointing towards using specified but not owned assets.
  • Cooperate. Set up a team from the business units mentioned above, and make sure they will help you in identifying leases not only during the implementation effort, but in a continuous basis.

Analyse contracts

Well, this is the step of reading contracts. No lease implementation project could skip this step, and probably cannot be avoided in the future. The key points here are the following:

  • Simplify as much as possible – if you use a lease identification questionnaire, you can probably delegate it to even non-accounting team members. Many “lease decision trees” are available in public technical literature, which are useful but their language is often “heavy accounting”. We rather propose descriptive questionnaires in simple English, explaining the reader what to actually consider when looking at a contract.
  • Document the conclusion – not only stating that A and B contract contains lease, while C does not, but also why it was concluded. It will help later on, especially when a contract is modified, to shorten the time of re-assessment. It also facilitates the audit process.
  • Appoint a contract owner. It is essential for contracts with a significant lease element (in terms of accounting materiality) to have a follow-up mechanism in place: any modification, cancellation or expansion of the contract triggers changes in lease accounting you must be aware of (at lease earlier than your auditors). A contract owner is not necessarily someone from the accounting team!
  • Ensure accessibility to contracts with lease elements. Establish an sps-site, an internal (electronic) document storage or a Dropbox folder to keep the contracts accessible. It can eat up enormous time to find several year-old documents later on.

Assess impact

Whether you are still implementing IFRS 16 or analysing a new contract, you have to consider certain exemptions allowed by the lease standard. Examples are whether an identified lease is low-value or a short-term one, or is it a lease of intangible assets. When adopting IFRS 16, you have to make a decision on restating all the comparative periods (to enhance understanding) or apply the new requirements from the current financial year only (modified retrospective approach). Similar exemptions should be considered when adopting IFRS for the first time, as per IFRS 1.

Another critical factor in making sustainable IFRS 16 compliant lease accounting is to have a general well-structured template to extract relevant data from each of the lease contracts. The details and complexity of such templates depend on the materiality of leases and the software solution you are using (see below). Any lease calculation, journal entry posting and audit review becomes much easier and error-free if a uniform lease database is used, as opposed to a contract-by-contract spreadsheet approach. It can also support using the portfolio approach in accounting for leases, if it is applicable.

You should also model the accounting impact of using IFRS 16, just to make key stakeholders aware of what to expect. A high-level estimate is usually enough before making a decision on the complexity of IT solution to be selected.

This is also the step where you have enough information available to make a reliable estimate of the resources you will need to implement and (equally importantly) run the lease accounting.

It is useful to validate the assessment results with your auditors as well, even before the year-end audit begins.

Implement sustainability

And finally implement lease accounting – but do not approach it with a “let’s get over with it and move on” style. You also have to have the proper processes and framework to address new contracts, modifications, management questions and audit trail. Furthermore, a resilient implementation means that subsequent organizational changes (employees leave and come) should not have an impact on how lease accounting is actually made. So you should think about at least the following:

  • Accounting policy and disclosures – updating the accounting policy might be evident, but the point here is to make it very clear and user friendly. Make it descriptive, even with illustrative examples, and definitely include the questionnaire we discussed above. Also, keeping the required IFRS disclosures in mind (even those which are at the moment not applicable or not material) and considering them during implementation will help to avoid excessive work later on.
  • Consider other regulations – procurement rules are subject to review to help timely lease identification. It might be worth discussing with legal team on certain contract types or template contracts, for example to make it clearer whether an asset is explicitly identified in such a contract type or not. Also, leasing as a financing method is usually regulated and managed by the treasury team. With IFRS 16, the related regulations should be revised, since lease means something very different from financing perspective than for accounting purposes.
  • Set up process and narratives. Lease accounting does not start and usually does not end within accounting. Therefore it is highly important to have a separate process chart and process narrative, identifying who is responsible for what. Based on our experience so far, one of the most challenging areas is to harmonize lease accounting postings with the current AP (accounts payable) process, at least for companies in Hungary. Process elements include lease identification, contract modification and providing data for reporting purposes.
  • Carefully select your lease solution. Basic instinct says that spreadsheets will just might do it. In some cases yes, but when we are talking about hundreds of lease contracts, it might get a bit challenging. Also, lease calculations can be sometimes quite tricky and complex (especially during reassessments and modifications) – it might be simply too time-consuming for the accounting team to become capable of addressing all these in spreadsheets. At the other end, major ERP suppliers integrate lease solutions into their existing modules, which might result in an expensive and complex upgrade project – it might not worth it, as the Hungarian proverb says, let’s not shoot a sparrow with a cannon. There are some very good products out there to help you in creating a sustainable lease accounting process (our favourite is Spiderpig). The most important is to make your need-weighted choice considering at least the following aspects:

 

  • What is the approximate number of lease contracts?
  • What are the implementation criteria, including system requirements, data protection and information security aspects?
  • Single user, multiple users or multiple parallel users?
  • Full-scope accounting (discounting, contract modifications, journal entry specification, automatic posting, disclosures) is needed or only partial tasks are expected?
  • Is lease accounting applicable for company-only reporting, for reporting package only, or looking for a solution which supports consolidated reporting with multiple legal entities also?
  • Do you need full subledger (right of use assets and lease liability on a contract-by-contract basis) from the solution directly?
  • Actual reporting or also planning / forecasting shall be covered (ie. should the solution be able to roll forward the lease payments, the amortization of the right-of-use asset and the unwinding of the discount from a specific point in time)?
  • Should the solution also serve as a lease contract storage (maybe with contract-specific master data, like expiration, renewal etc.)?
  • Language of the solution – might be a bottleneck if IFRS is used for statutory purposes but does not contain local language.
  • Cost structure (licence fee, maintenance, support, implementation)