When comparing companies’ balance sheets pre- and post-transition in late 2019, research showed the new lease accounting standard led to average balance sheet lease liability increases of nearly 1,500%. LeaseQuery recently put together the Lease Liability Index Report to take a deeper look into major liability increases by industry. With such massive changes on the horizon, audit teams must begin preparation early on, becoming familiar with a client’s implementation plans to tackle the transition to ASC 842. Further, an understanding by the auditor of the company’s volume and nature of operating leases, will help determine the level of audit effort necessary during transition.
Based on lessons learned from public company adoption, companies should anticipate that the implementation will be more complicated and more time consuming than originally estimated. Additionally, with the average balance sheet liability increasing nearly 16 times under the new lease accounting standard, auditors should also brace for a significant uptick in hours required to complete audit procedures associated with the new standard.
This phase of our article series will focus on the audit planning stage, providing key areas engagement teams should concentrate on during planning discussions to ensure expected hours meet client-specific needs.
*Stay tuned throughout the calendar year for further updates on risk assessment, control testing, substantive testing, and year-end disclosure.
Current lease accounting/management process
A company should consider where decision-making and record-keeping for contracts has historically been managed. Given the potential materiality, many companies may have centralized record-keeping/review of real estate leases through the financial reporting department; however, more routine contracts—such as equipment or vehicles—may have been managed/reviewed at a divisional/departmental level. The company and its auditors should review this process to ensure that all relevant contracts have been appropriately identified/classified as lease agreements.
Additionally, many companies have not performed an in-depth process of searching through service contracts to identify embedded operating leases, since the income statement impact was not materially different if the arrangement was accounted for as a service contract versus an operating lease. For clients with a significant number of service contracts, the search for embedded leases will need to be completed prior to adoption. This search can add a significant number of hours to the accounting department’s workload. Since errors cannot be grandfathered, understanding the company’s process and working through any leases identified in 2020, will help reduce the work on adoption and also help ensure the completeness of your lease portfolio prior to transition.
Company’s implementation plans
Currently, many private companies utilize Excel to track critical lease dates, payment information, reconcile general ledger accounts and accumulate financial disclosure data. The new standard requires expanded quantitative and qualitative disclosures. Given the requirement for such significant quantitative disclosures, continuing to track this data in Excel can result in accounting errors, such as a result of an individual’s misunderstanding of the accounting guidance or an error within the Excel workbook.
If a company has any new leases or modifications to a lease, accounting for these scenarios requires significant effort to ensure they are accurately reflected in the Excel schedules. Further, for electronic audit evidence rules, an auditor must test these Excel schedules for each schedule used, resulting in increased audit effort. Understanding a company’s plan for managing the accounting for leases under ASC 842 will serve quite beneficial in determining the level of audit effort on transition.
A company’s plans for implementing the new standard serve as a direct input into determining allocated audit hours. While some companies believe current processes will function well enough to maintain compliance, most organizations with multiple leases will implement lease accounting software. Selecting and implementing the right lease accounting solution for your business will provide the most efficient and effective route to compliance. As a company selects its software, it should ensure they ask the appropriate key questions around specific service offerings. Certain vendors may prioritize the administrative management of contract portfolios, while other solutions may specifically focus on the accounting compliance aspect.
Client resources allocated to managing the lease portfolio
Auditors should understand the number of individuals and departments currently involved in the management and accounting for the lease portfolio. Public companies have found that given the broad reach of lease contracts, the manager for the lease project should identify a multi-disciplinary team. Client communication within the organization should expand across many departments to ensure completeness of the lease population. We would expect a similar inter-departmental approach for private companies as well.
The audit team should gain an understanding of the upcoming accounting transition. Many companies may have accounted for real estate contracts already; however, due to minimal balance sheet impact, operations groups outside of the accounting department may have taken on the full management of equipment leases and embedded contracts. If this is the case, auditors should remain on high alert for missing or potentially ineffective controls surrounding the new lease accounting assertions. To validate the completeness assertion, the auditor should understand the procedures the company will perform in terms of reconciling AP payment detail for service contracts with lease reconciliations, reconciliation to the Commitments & Contingencies footnote support, inquiries with other locations/IT, etc.
Qualitative considerations regarding the lease portfolio
A company (and its auditors) should consider the resources that have or have not been involved in lease decisions historically. For example, if the real estate team has historically served as the primary team managing the lease management process, auditors may want to remain skeptical about the entity’s ability to seamlessly transition to the new accounting standard.
A company’s nature of lease arrangements can also impact an auditor’s plans. The accounting process for a master lease of equipment leases, or a group of copiers/servers, will pale in comparison to the complexity for companies that lease several unique buildings or pieces of equipment. This will, in turn, drive an auditor to evaluate the typical complexity of an organization’s leases. Unique payment structures, as well as renewal and termination options, can cause a lot of confusion with the ASC 842.
The FASB has highlighted the complexity of this accounting standard implementation, scheduling a meeting on May 18, 2020 to discuss some of the areas that public companies struggled with on adoption. Given the exhaustive efforts that public companies have found during adoption, audit firms should meet early with their private clients to ensure that their ASC 842 implementation plan is comprehensive and allows time to complete before the private company transition date. These planning efforts from the audit firm will help to reduce surprises later.