How Procurement Can Help Save The World From ‘Lease-Pocalypse’
Spend Matters welcomes this guest post from Steve Keifer, LeaseAccelerator’s vice president of marketing.
In less than 90 days, one of the biggest accounting changes the world has ever witnessed will start to take effect. Starting in January 2019, a new set of rules will require companies to begin transferring almost $3 trillion worth of leases onto their balance sheets. Historically, these leases have been hidden “off balance sheet,” buried in the footnotes of SEC filings and annual reports. But going forward, they will be center stage in financial reports. Just as companies list “fixed assets” they own such as plant, property and equipment on their balance sheet, they will now need to have a line item for leased assets as well. And just as companies report on short-term and long-term debt, they will need to report on lease liabilities as well.
$3 Trillion in Corporate Leases
Companies lease (rather than buy) many of the assets they use to run their business. For example, companies typically lease the real estate used to support their operations — from factories and warehouses to stores and office space. Leasing touches about every spend category across the business. Companies lease IT assets such as laptops and servers; material handling equipment such as forklifts and pallet jacks; and transportation assets such as company cars and executive jets.
Historically, one of the attractive elements of leasing (rather than buying) has been the ability to keep the liabilities for the contracts off the balance sheet. However, with the new leasing standards (ASC 842 for U.S. GAAP and IFRS 16 for international reporting), the accounting benefit goes away. When the change was first proposed by U.S. and international accounting standards boards, there was widespread panic.
Critics of the proposal argued that companies with large leasing portfolios would have billions of dollars of additional liabilities added to their corporate balance sheet, potentially resulting in downgrades to credit ratings and leading to challenges in raising capital. Many worried that companies would stop leasing altogether to avoid the balance sheet impacts. One study projected that over 3 million jobs would be lost and that U.S. GDP would be reduced by almost half a trillion dollars due to the introduction of the new standards, according to Chang and Adams Consulting.
Fortunately, there has been no sign of the predicted “lease-apocalypse.” But for accounting teams racing to meet the January 2019 deadlines, widespread panic still remains. The good news is that procurement can play a big role in helping to save the day.
Procurement’s Role in Lease Accounting
To apply the new accounting standards, a detailed understanding of the leasing contracts is required. This is the kind of intimate knowledge that only the procurement team has, placing it in a unique opportunity to assist understanding the fine print of contractual arrangements.
In recent years, leasing contracts have become more complex bundles of assets and services. For example, a photocopier lease might include not only the actual machine, but also a maintenance contract from the manufacturer as well as resupply contracts for paper and toner. All of these services might be rolled into a lease agreement for which the customer pays a price-per-page. Commercial real estate leases can be even more complicated as many landlords bundle rent payments for a property together with other fees such as insurance, taxes, utilities, landscaping and custodial services. All of these expenses are rolled into a single monthly invoice for which the customer pays a price-per-square foot.
These types of full-service arrangements can create lots of complexity for accounting teams. The new standards allow accountants to separate a lease into different components — some of which are carried on the balance sheet and others of which do not have to be. But to take advantage of this option, accounting will need help from the procurement teams that negotiated the contracts to identify the contracts with bundles of leased assets and the individual products and services being provided by the vendor.
Leases Hidden in Outsourcing Agreements
Perhaps, the greatest challenge with the new accounting standards is that the definition of a lease has expanded to include assets bundled into outsourcing agreements, service contracts, and “as-a-service” offerings. In other words, contracts that a lawyer or a banker would not consider a lease, may be considered leases for accounting purposes. For example, if you outsource production to a third party, then the factories, machinery and other equipment being used by the contract manufacturer may be considered a lease. If you outsource storage, distribution or transportation to a third-party logistics provider, the warehouses, forklifts and trucks being used by third party logistics may be considered a lease. If you outsource management of IT applications to a third party, then the servers, storage devices, networking equipment and data center facility used by the IT provider may be considered a lease.
The accounting standards provided a detailed set of criteria to help determine which contracts contain an embedded lease and which do not. However, no one has been able to develop an artificial intelligence algorithm to automatically perform the analysis. As a result, accounting teams will need to read carefully through the fine print of thousands of different contracts to understand the details of who controls the assets and how they are used. And they will need the procurement teams help to identify which contracts to review and understand the business terms of the arrangements.
Beyond the Deadline
The short-term priority for procurement teams will be to help their peers in accounting to make the January 2019 deadlines. However, the longer-term need will be to establish an on-going process to keep the accounting for leases accurate. Procurement will play an important role in identifying potential leases as new contracts are being negotiated. They also will need to help track changes to existing contracts such as renewals or contract modifications. Even a slight change to a contract could result in an agreement shifting to fall within the scope of an on-balance sheet leasing arrangement.