It Figures Podcast: S3:E12 – Lease Accounting is for EVERYONE

Intro:

From Carr, Riggs, and Ingram, this is It Figures: The CRI podcast, an accounting, advisory, and industry focused podcast for business and organization leaders, entrepreneurs, and anyone who is looking to go beyond the status quo.

Lorri Kidder:

Welcome back to another CRI podcast. I am Lorri Kidder. I am a partner in the Bradenton, Florida office of CRI. My subject matter expertise is in nonprofits. I do a lot of single audits. And I’m doing this podcast with Alyssa Hill. Alyssa, would you like to take a few minutes and introduce yourself?

Alyssa Hill:

Thank you, Lorri. Hi, I’m Alyssa Hill. I am a partner in our Houston, Texas office and I’ve had the pleasure of working with nonprofit organizations for almost 25 years and like Lorri, do a lot of single audits as well. So pleasure to be here with everyone today.

Lorri Kidder:

Okay. And today we are going to talk about leases, which is for everyone, not just nonprofits, right, Alyssa?

Alyssa Hill:

That’s right.

Lorri Kidder:

So many of you have probably in the not too distant past went through the revenue recognition transition when those new standards came through and I think a lot of clients did not feel like there was a lot of change. But I think you’re going to find that the new lease standard actually does provide quite a bit of change and it’s something that we really need to start looking at if you haven’t already and start working on that. If you’re not familiar with the lease standard, I recommend that you look up ASC 842 and start reading and studying up and talking to your CPA. So Alyssa, we’re going to talk through a few things. We’re going to talk about how to identify leases. We’re going to talk about how to obtain the source documents and we’re going to talk about things that we need to consider when we’re looking at leases and getting them set up as well as maybe some future policies and procedures that we should put in place. So Alyssa, to get started, let’s just start with how do you identify your leases? How can we find them all?

Alyssa Hill:

Well, that’s always the first step, is identifying your population. So identifying those leases and a couple things, there’s going to be the obvious ones. If you lease your office space and you’re standing in your office, well guess what? You’ve got a lease. You pass by or use those copiers. Those are some of the obvious ones that you’re going to need to look at and consider. There’s other areas or other items that may not be so obvious and those relate to what’s referred to as embedded leases.

So we need to be looking and considering those as well. But it’s real important obviously that we get the right population and that you identify everything that could be a lease. And just for reference, or just for reminder purposes, the definition of a lease. So a definition is a… It’s going to be a contract or an agreement or even part of a contract that’s going to convey the right to control the use of a specified asset over a period of time in exchange for consideration. So as you’re thinking through, “Well, what possibly does my population look like?” Well, I always want to make sure we’re going back to that definition at the end of the day to make sure everything’s incorporated.

Lorri Kidder:

Hey Alyssa, could you give us just an example of what an embedded lease is?

Alyssa Hill:

Oh sure. So an embedded lease is going to be something that’s within obviously a larger contract. That contract may not scream or say lease on the top of it so that’s where we can get into some difficulties. Typical places where you may find an embedded lease, IT contracts, because if you think about it, you may have a server or you may have some assets that you have as a part of a larger service contract. So you’d be looking at what’s included in your IT contracts, manufacturing equipment. That is always a big area that you could have leases in. One that maybe a little more unique for our nonprofits. If you think about a museum that has a cafe, well you may have a service contract with a third party to manage and operate that cafe. Well is there equipment within that cafe that’s being used as a part of that contract that may meet the lease definitions? So those service contracts, things that are outsourced, supply contracts, maybe advertising, transportation. So there’s a lot of different areas that those could appear.

Lorri Kidder:

Alyssa, so as part of identifying the leases. How do you recommend that people go about identifying them? How can they actually make sure that they accumulate all of this information?

Alyssa Hill:

Yeah, so the first place, Lorri, the first place I’d say is obviously what you already have. You might have a capital lease schedule, schedule or operating lease schedule that you’ve been using for your annual audits or reviews or for internal purposes. So that’s always a good starting point because that’s what you know have. Then the other thing we recommend when we’re talking with folks about this is just go through your general ledger detail. Look for recurring payments on a monthly basis, maybe a quarterly basis because that might indicate some type of service contract where you may need to look a little closer or just a recurring payment that maybe wasn’t on your original schedule. So GL is a great place to start. Other thing, just walk your office if you’ve got a manufacturing facility, walk that, just look for things that might be equipment or some of those other things that could be leases.

If you have multiple departments that are responsible or… It’s not responsible but are able to enter into contracts, be reaching out to all those departments because what do we know? Not everything always makes it to the accounting department or centralized location. So depending on who within your company or organization has the ability to enter into contracts, those are going to be key people to talk with because they’re going to know what they have. So the general ledger physical inspection, what do you know already have, are all great places to start. And I will… You may be thinking that, “Oh I don’t have any embedded leases. I know everything that I have.” Well there’s been quite a few surveys done and a couple that, more recent ones that up to 58% of respondents are identifying embedded leases they didn’t know they had so it’s not what I would say a one off there may be more likely to be found than you may be thinking about.

Lorri Kidder:

Wow, thanks for sharing that. That’s interesting. We all need to be looking for those as we go through our contracts then. Okay, so we’ve hopefully accumulated all of the source documents, the contracts, what kind of information do we need to be accumulating out of those documents in order to properly record leases?

Alyssa Hill:

So once you’ve got that, you’ve got your contracts, you need to be looking at some of the basic things you probably look at in most contracts is, and first off being what’s the contract term? Because one of the things with the lease standard with the newly standard ASC 842 is leases that are less than 12 months aren’t going to have to go through all of the calculations to determine what’s going to get reflected on your financial statements as a right to use asset and lease liability.

So lease term is always important. Renewal options, you need to pay attention to those because renewal options do have to be considered. And what’s your base term and then do you have five year renewal options? Three year renewal options, what do those look like? What are the termination rights within that. Also, look for, because it maybe it’s might have been an ongoing lease for a couple of years, maybe a little bit longer. Were there any lease incentives in there? And that includes free rent, which who doesn’t want free rent as a part of their long term lease contract. So you need to be looking for things like that as well. Any of those types of incentives that you may have had.

Lorri Kidder:

So are there other kind of things that we need to be considering? I’ve heard a lot about discount rates as of late.

Alyssa Hill:

Yes. So that’s kind of almost when you’re getting to the next step of, “Okay, I think I have everything or I’m really confident I have everything. I’ve looked through the contracts, I know my key start dates, my end dates, my renewal options, any lease incentives I have, any escalating rent that maybe they’re, I’ve got my hands around all of that.” So then the next piece really you’re going to start getting to is, well now, “What do I do with that, I have all this information, how do I go about determining the amount of the lease liability that’s going to be recorded?” And one of the big factors there is the discount rate. So with the discount rate, there’s really three options with that. One is if the rate of the lease, if you know what that rate is, then you have to use that so that’s easy. If it’s in there you’ve got to use it.

But what happens, and what we’re seeing is as a lessee, you don’t really know what the lessors rate is. You don’t know their profit that’s built into it. So you don’t readily know that. Well, if it’s not readily known, you don’t have to go to try to figure it out. If it’s not readily known, then you’re going to go next to an incremental borrowing rate. And one of the things that you need pay attention to, I think with the incremental borrowing rate is it is on a collateralized basis, which is different from the legacy standard. So you’ve got to… It’s not just your line of credit rate. You’ve got to determine, “Okay, well what would be my incremental borrowing rate on a collateralized basis for a lease of a building over 10 years or for this piece of equipment over five years?” It’s not going to look the same for every single lease. There could be variations with that.

So there are some estimates and if you are an organization or a company who has not had to rely on borrowings, that’s not something you probably have in a file or in your back pocket. So it may mean you’ve got to reach out to lenders to get some estimates of what that rate would be for you. But again, the collateralized basis, that’s real key to remember. Now because that again is an incremental cost that you’ve got to go through and there’s some complexity to it. There is one other option that you can use, which is the risk free discount rate. So that’s like the UST bill rate and go online, get that pretty easily. So that is an option for a rate to be used. I will just caution a couple things with that is one, the rate needs to be for a similar term.

So if you’ve got a 10 year office space lease, you’re not just going to go get the T-bill rate today. And so that’s my rate. It needs to be for a similar close period that you can get so if your office lease is 12 years but there’s a 10 year rate, then you’re going to use the 10 year rate. You’re also not going to use today’s rate, you’re going to use the rate of the date of implementation or the lease commencement. So there’s a couple different ways you could look at that as to what rate you’re going to use. But it’s not just today’s rate. So I would just caution everybody to remember that. But that is absolutely an option that is available to use. You do not have to use it across… It used to be it was all or none, but now you can use it by class of asset if you take that election. So by class asset you could elect to use the risk free discount rate if needed.

Lorri Kidder:

Wow. Alyssa, that is a lot of information to-

Alyssa Hill:

Is that a lot?

Lorri Kidder:

Accumulate. So my next question is how am I going to track all this information and accumulate it so I can track this information in my general ledger?

Alyssa Hill:

So I think there’s two parts to that. There is the actual tracking of the information that will give you everything that we’ll need to go on to your financial statements, on your balance sheet, how you’ll recognize the least expense through your in income statement or statement of activities and how that’s going to be reflected.

But before you even get to that, or in conjunction with getting to that, you’re going to want to make sure you have documented, if your leases have option periods and you have chosen to elect or not elect to include those option periods, you need to have that documented just like if you are using an incremental borrowing rate or a risk free discount rate that you’ve got your basis documented for that as well. All of that goes into your calculation of your lease liability and right use asset. So you need to have that documented to be able to support the components that you’re using in the calculation. So now to your actual question, tracking this, there are Excel options out there that you can certainly use. And then there’s softwares out there as well, CRI Analytics has a Centrally software-

CentraLease:

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Alyssa Hill:

That allows you to track that information. Depending on the number of leases, you may find if you really only have a couple of leases, Excel is perfectly fine. But if you’ve got maybe 10+ leases or 15 or 20 leases, different categories of leases, maybe you’ve got a heavy vehicle fleet or heavy equipment, that type of thing, you may find that an automated software is easier because a lot of times you can upload information from a spreadsheet to the software to do the calculation. Also, how often do your leases renew if you’re renewing them every three years or their modifications every three or five years, All of that. You’ve got to be able to track all that. So it really comes down to what’s, I think to me it’s the volume and the complexity of it as to really how maybe the best way is to manage all of this information. It’s definitely the first year, it’s a process. I mean it’s… Compiling all this information, determining all of your rates, your renewal periods, all of that, Just getting your hands around of it all and entering it. That is an exercise in itself.

Lorri Kidder:

So let’s say we’ve done all that, we’ve gone through, we’ve identified all of our leases, we’ve obtained all the source documents, we’ve gathered all this data, and we’ve either done it in Excel or we’ve purchased some kind of software, maybe even the CRI Central lease. What do we need to do going forward as an entity? What should we do going forward to make sure that we keep tracking these correctly?

Alyssa Hill:

Well, depending on how cumbersome and hair pulling your initial exercise was will probably dictate what you want to do going forward. But in all honesty, a big piece of this is going to be probably finding that you need some new policies and procedures as a part of this. As you know, I can think of where… Especially if you have a very decentralized purchasing or contract type entity, having a policy that says, “Okay, anytime anybody enters into X number of contracts it’s got to come to accounting.” Because you don’t want to every year at the end of the year or getting ready, even next year, getting ready for your audit, trying to go through and say, “What do I have? What’s my new population?” There can be things at least on an annual basis that you would find might be useful, which is going through that general ledger, again, looking for recurring payments, something you didn’t have.

Your policies and procedures definitely of keeping track of when leases are getting ready to expire, when renewal options are coming up. Maybe you’re going to elect a policy that says we are always going to use the risk free discount rate for classes of assets if the lessor rate is unknown, because remember that again, if the rate’s in there, if you know the rate, you have to use it, but absent that, you have your other options. So really… I mean, the recording of it, who’s going to be responsible for that? And really just the gathering of that information to make sure that you’re keeping track of it real time, I think is important.

Lorri Kidder:

Great. Thank you, Alyssa. You have provided so much great information going forward and just anyone who’s listening to this podcast, if you have not started looking at your leases and you are a 1231 year end, I recommend that you get started identifying that information, gathering the documentation that you need. And please feel free to reach out to CRI if you have any questions, we’d be happy to help.

Outro:

If you want more CRI Insights or are interested in learning about our firm, please visit our website at www.criadv.com. Thanks for listening to this episode of It Figures, the CRI podcast. You can subscribe to It Figures on iTunes, Spotify, or wherever you prefer to listen to your podcasts. If you liked what you heard today, please leave us a review.