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Because of its impact on the Office of Finance, I’ve written in the past about the proposed timeline and IT implications of the convergence of U.S. Generally Accepted Accounting Principles (U.S. GAAP) and the International Financial Reporting Standards (IFRS). While the bottom-line differences between U.S. GAAP and IFRS are likely to be minimal for most businesses, some aspects of the convergence promise to be significant and problematic. One important change is how companies account for leases. The process of arriving at these rules has been contentious because it represents a major change that will entail substantial process and accounting challenges for U.S. GAAP companies. These changes are likely to go into effect as part of U.S. GAAP well ahead of any adoption of IFRS in the U.S. IT systems also will be affected, but software could smooth the transition if vendors provide a workable product.
The proposed change to lease accounting involves a sweeping conceptual change from the operating lease model, which simply records lease payments as they occur, to a right-of-use model, which reflects the present value of the future lease payments as a liability along with a corresponding asset on the balance sheet. The objective is to more accurately reflect a company’s financial position by presenting a more complete calculation of its financial liabilities. Although future material lease payments must be disclosed, currently this information is found in the footnotes.
The new approach to lease accounting will increase the workload of the accounting function, as it involves two phases: the initial posting of all existing lease liabilities and the posting of ongoing transactions related to recording leases and amortizing them over time. Gathering all relevant information about all leases will be problematic because the information may be scattered and details may be missing, and getting it into existing accounting systems will add to the burden. Moreover, on an ongoing basis, those entering into a lease will need to capture the corresponding information at the time of the initial transaction and transmit it to the accounting department.
As things stand, it’s very likely companies will default to using desktop spreadsheets for data collection and even for period calculations, which is a shame because they certainly are not the best solution. Given that the data in these spreadsheets is likely to be copied and rekeyed, it is prone to error. Indeed, our research confirms that this issue is common with 35 percent of organizations have data errors compared to formula errors (24%). Maintaining spreadsheets is also likely to be time consuming, which is another common problem where organizations spend up to 18.1 hours per month on these tasks. Spreadsheets are not the best means of tracking the various lease terms or the forward-term and variable rent assumptions an organization needs to store and track to accurately compute the value of assets, establish the initial lease liability and calculate its amortization over time. Moreover, the current guidance envisions a requirement that companies regularly reassess lease terms to determine if conditions that affect the valuation or amortization of the lease have changed. For instance, if economic incentives to renew the lease term change following the initial contract, that must be reflected in the valuation. If, say, a contract for a two-year lease is amended to include attractive options for renewals extending out an additional eight years, the liability on the balance sheet (and corresponding right-of-use asset) will increase.
Those entering into and managing leases are not necessarily accountants with access to core financial systems. Rather than having to rely on spreadsheets or make extensive changes to their ERP and financial systems, what companies need is a lightweight lease application that could be used by accountants and non-accountants alike. Such an app would serve as a distributed data entry vehicle to capture and update all relevant lease information, as well as an analytical tool for managing lease-related calculations. The software would need to provide the low-cost and ease-of-use characteristics of a spreadsheet but offer data connectivity and the controls of an enterprise application. It might even use a spreadsheet interface to give users a familiar environment in which to work. However, unlike a spreadsheet, the application would enable both flexible and consistent data entry for even the most complicated leases. The characteristics of individual leases could vary, but in almost all cases their basic structure, terms and conditions would follow a straightforward model. Rather than relying on uncontrolled email-enabled workflows, the process of entering information about a lease, reviewing and approving it as well as handling periodic reviews and updates would be handled by defined and auditable workflows. Rather than having to re-key information from a spreadsheet into financial systems, such an application would automate the process of posting information to financial systems.
The coming changes to lease accounting will present companies with substantial business challenges. Although there will be no real change to their economic condition, the increase in assets and liabilities may affect some companies’ credit rating or require changes to loan covenants. Recording and tracking leases will become a greater burden than before – in some cases considerably so. Therefore, it would be great if vendors could provide a low-cost, low-maintenance application to help corporations and their finance departments manage leases, reduce workloads and ensure accuracy.
Robert Kugel – SVP Research
Financial analysts typically classify real estate as a fixed cost. Strictly speaking, that’s correct, but looking at it this way leads many organizations to overlook and miss opportunities to more carefully manage their real estate and other occupancy expenses. In industries where occupancy or ownership costs account for more than 20 percent of total business expense, taking a more active approach to managing real estate and occupancy can improve a company’s profitability. But in most cases achieving a higher return from money spent on corporate facilities requires some organizational and process changes.
For many companies the fact that real estate is a fixed cost means that they rarely spend time considering their options for reducing this expense or making better choices for locations and facilities. Industries in which occupancy costs are one of the top three expense categories, such as retailing or consumer-oriented financial services, pay more attention; these businesses often have departments responsible for managing leasehold costs, site selection and other aspects of occupancy. But other businesses also could control this expense much more effectively. There’s an organizational component to this: centralizing occupancy management as a shared service. There’s also a technology component: ensuring that all relevant data is readily accessible through a dedicated application – not spreadsheets – to manage the administration of these sites.
Larger companies that are not big retailers may have a substantial number of offices and other leased locations that, when taken all together, offer a sizable opportunity for managing their utilization and cost more advantageously. Yet most distribute the responsibility for handling these sites across divisions, business units or even more narrowly. Managing real estate across the entire company as a shared service may be a more efficient approach. A central real estate management function can support all of the business units’ real estate decisions, monitoring and managing enforcement of lease terms and conditions as well as enabling a more long-term, strategic approach to facilities. So it’s important that if a company centralizes its real estate function it has the full range of capabilities to support the business units that will be utilizing the space.
Software can provide some of those capabilities. One of the powerful transformative contributions made by information technology has been to change the given constraints of running a business. Often, the connection between these advances and technology is difficult to see because of the inevitable lag between the introduction of new capabilities and when they help produce better processes. For example, companies do a far better job of managing physical goods than a generation ago; computers made lean inventory management feasible for average organizations. Over the past two decades, business processes have evolved as new categories of applications have become available and as the scope of information available for analysis and decision support has broadened. Managing real estate facilities and expenses is one of these areas where companies could save money and work more effectively with suppliers and customers.
Software designed specifically for managing real estate has many of the routine functions users need and often captures better practices than most companies are using. For example, many companies could make better-informed decisions when it comes to arranging or renewing leases. Typically, the individuals who are responsible for a particular site or business unit rely on brokers to keep them in touch with real estate availability and market conditions. While brokers can be invaluable for many services, they may not know (or provide) everything that is appropriate and available. Software that taps into commercial real estate databases can provide insight and analysis that enable companies to negotiate better terms than they might otherwise. Moreover, once a lease is negotiated, companies routinely do not follow up on all of the provisions that can save them money, such as those limiting assessments, or fund improvements for structural enhancements beyond an initial build-out; real estate applications can keep track of these contingencies. A software-supported shared service approach also can do a more effective job of handling day-to-day administrative tasks such as managing maintenance and construction costs or optimizing space utilization across the organization.
Spreading the cost of dedicated software across the entire organization makes this approach more affordable. Taking the process off a manual approach using desktop spreadsheets makes it more effective. It ensures that processes are handled consistently, deadlines are anticipated and follow-throughs are performed.
Occupancy expense is an item that many companies watch but do not have the methodology and capabilities to manage well. In some cases it may make little difference, especially if a company’s occupancy costs are a small percentage of operating expenses or if it operates in a small number of locations. But many Global 2000 companies, even those that are not in businesses that require them to manage a large number of retail sites covered by complex leases, can benefit from taking a more strategic approach to managing their occupancy costs. They can reduce their ongoing expense and have sites that better suit their needs.
Robert Kugel CFA – SVP of Research