With the first year of the new lease accounting standards implementation complete, organizations find themselves at a critical juncture — the commencement of "day two" accounting. While the initial phase focused on negotiating terms, finalizing agreements and setting up initial accounting entries, the spotlight now shifts to the long-term management of lease accounting.
The importance of establishing an effective and sustainable lease accounting strategy cannot be overstated. Beyond the initial challenges, organizations must now navigate the complexities of ongoing financial statement reporting. This demands a proactive approach to recordkeeping, ensuring accurate and up-to-date information for lease management and accounting.
To successfully navigate day two and beyond with lease contracts, organizations must move past manual processes and spreadsheets and instead implement lease accounting software solutions. Software not only streamlines operational efficiency but also ensures compliance with accounting standards, mitigates risks and optimizes decision-making processes. It simplifies lease revisions, including modifications, renewals and terminations, which could take hours or days using spreadsheets. Due to the complexity of requirements for lease revisions, spreadsheets also have an increased risk of inaccurate calculations.
Moreover, utilizing software enables a future-proof approach to lease accounting, allowing organizations to quickly adapt to updates in accounting regulations and facilitating strategic planning and budgeting by providing decision-makers with lease data to optimize structures, negotiate favorable terms and seize business opportunities. Additionally, before entering day two, organizations should conduct a thorough review of calculations and data inputs, considering the tools and methodologies employed to build a comprehensive and forward-looking lease accounting approach for ongoing success.
Creating a sustainable process for day two and beyond
One of the key elements for efficient day two lease accounting is creating a sustainable process that can handle the myriad complexities of ongoing lease maintenance. This includes revisiting calculations for events such as modifications, remeasurements and terminations of leases.
Creating a systematic procedure that facilitates lease accounting for periodic reports and reconciliations involves asking several questions:
1. Are there any updates or modifications to leases, including additions, terminations, reductions, extensions or impairments?
Leases aren't set in stone after an initial agreement is signed. Changes can occur at any time, such as the addition of new terms, the reduction of lease assets, extensions of the lease period or even impairment of leased assets. Each of these modifications requires immediate attention in lease accounting to ensure they are accurately reflected in financial reports.
2. Have there been any modifications to service agreements that may involve embedded leases?
Embedded leases — where a lease is part of a larger contract — are often overlooked but can significantly impact financial statements. For instance, a service agreement might include the use of specific equipment, which would count as an embedded lease. Keeping track of these changes is crucial to ensure comprehensive lease accounting and compliance with relevant standards.
3. Have there been any revisions to assumptions made regarding lease extensions or purchase options?
Leases often include options to extend the lease term or to purchase the leased asset. The assumptions made regarding the likelihood of these options being exercised can significantly affect the lease's accounting treatment. Therefore, any revisions to these assumptions necessitate a review and possible adjustment of the lease accounting.
4. Have there been any leasehold improvements made during the reporting period?
Accounting for leasehold improvements — changes made to a leased property — depends on who is paying for that improvement. If the lessee pays for improvements and the lessor provides some or all of the funds to the lessee, funds provided by the lessor could be considered an incentive that should be included in the lessee's right-of-use asset calculation.
5. Is there a systematic procedure implemented to ensure the integrity and precision of lease data?
A systematic procedure for managing lease data is fundamental to achieving accurate, reliable lease accounting. This includes everything from the organization having strong internal controls around collecting and recording lease data to regular reviews and audits. This system might include data validation checks, reconciliation processes and audit trails. Having these procedures in place will help prevent errors, inconsistencies or potential fraud, ensuring the integrity and precision of the lease data.
Answering these questions can help you to establish a strong framework for lease accounting and management, enabling effective tracking and compliance with accounting standards for lease agreements.
Changes to leases: when to reassess and remeasure
It's important to note that any changes to the lease terms may require businesses to reassess their lease accounting calculations. Here are some events that might trigger reassessment or remeasurement:
Reassessments might occur if:
1. A significant event or change within the lessee's control affects whether the lessee is reasonably certain to exercise or not exercise an option.
If there are significant changes that are under the lessee's control and could potentially impact the lessee's decision to exercise or not exercise an option, reassessment becomes necessary. This change could be anything from the organization's financial performance or strategic shifts to evolutions in operational needs. For example, if a company initially planned to not exercise an option to extend the lease but has since seen substantial growth in that area of its business, it might now be reasonably certain to exercise the lease renewal option, triggering a reassessment.
2. An event occurs that contractually obligates the lessee to exercise or not exercise an option to extend or terminate the lease.
Contractual obligations or specific events within the lease agreement might obligate the lessee to make a decision about extending or terminating the lease. For instance, the lease contract might specify that if the lessee reaches a particular revenue threshold, the lease must be extended. This event would require a reassessment of lease accounting.
3. The lessee elects to exercise an option even though the entity had previously determined that the lessee was not reasonably certain to do so.
When a lessee chooses to exercise an option that was previously determined as unlikely to be exercised, it will require a reassessment. For instance, a lessee might decide to purchase the leased asset at the end of the lease term, despite the initial assessment indicating that this wouldn't happen. This shift would change the lease classification from an operating lease to a finance lease, which has different accounting implications.
4. The lessee elects not to exercise an option even though the entity had previously determined that the lessee was reasonably certain to do so.
Similar to the previous point, if a lessee decides not to exercise an option that was previously thought to be reasonably certain, a reassessment of the lease accounting is required. For example, if a lessee was initially expected to extend the lease but chooses not to, this will change the lease term, affecting the lease liability and right-of-use asset recorded on the balance sheet.
Remeasurements might be needed if there is:
- A change in the lease term or the assessment of whether the lessee is reasonably certain to exercise a purchase option;
- A change in the probable amount being owed to the lessor under a residual value guarantee; or
- A contingency upon which some or all of the variable lease payments in the lease standard are based is resolved such that those payments become fixed.
In conclusion, the completion of year one marks only the beginning of the journey. As organizations transition to day two, they must recognize the importance of creating an ongoing lease accounting strategy that involves establishing a sustainable process that can handle the continual complexities of lease standards. Embracing technology-driven solutions not only ensures compliance and mitigates risks but also lays the foundation for sustainable financial growth and success in the world of lease accounting.
