Lessee Compliance: Rationale and Requirements Checklists
Despite Sarbanes-Oxley (SOX) and the millions that companies have spent on complying with its terms, the leasing process inside most companies remains an opaque, complex area of corporate finance. It is often characterized by poor lease accounting, decentralized management, broken processes and incomplete systems. These issues will lead inevitably to numerous control and compliance problems and costly financial mistakes.
In an effort to meet SOX and other compliance standards, today’s finance executives at lessees must focus on finding ways to maintain the accuracy of their accounts while simultaneously improving the company’s financial performance. SOX legislation has raised the stakes by introducing criminal penalties for company executives if financial statements do not fairly and accurately represent the financial condition and results of a company. The unfortunate reality is that executives lack the visibility, controls and resources needed to properly manage their lease and asset portfolios.
Financial executives of large corporates often dismiss the significance of leasing compliance because, in their view, their leasing activity is ‘not material’. However, they also acknowledge that they do indeed ‘lack the visibility, controls, and resources needed to properly manage leasing transactions’.
Executives must assume a realistic viewpoint when making ‘materiality’ judgments regarding their leasing activities in order to avoid undesirable consequences. The issue of materiality applies to many of the situations in which companies could be non-compliant with the laws, standards and requirements detailed below. The measure of materiality drives a company’s decision to disclose the risks it identifies – an issue of risk is material if there is a substantial likelihood that a ‘reasonable investor’ would view its disclosure as having significantly altered the ‘total mix’ of information. The US Securities and Exchange Commission (SEC) has warned firms consistently that materiality has no quantitative threshold. Even relatively small numerical differences could influence investors significantly. In fact, the SEC has warned companies not to make materiality determinations based solely upon quantitative measures, such as 2 per cent or 5 per cent of total assets. The SEC has also stated repeatedly that the purpose of disclosure requirements is to give the investor a look inside the company through ‘the eyes of management’. So if a company has $2bn in revenue and a lease portfolio of $20m to which a minimum of $10m in new transactions are added every year – is that prima facie ‘material’ to the company and its financial statements? There is no simple answer. However, if you understand the compliance requirements, you can evaluate the risks and the control environment and begin to answer the question.
The following discussion of compliance requirements is driven by our experience helping clients comply, optimize economics, and minimize risk in North America. However, the principles apply globally. Considering the current, intensifying collaboration between the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB), we should expect to see further convergence of the requirements.
Even without government oversight, leasing is complex. Like all corporate lessees, you can suffer significant economic loss unless you both comply with and manage your master lease agreements (MLAs), while also understanding and adhering to all applicable laws and standards. Each law and each jurisdiction – often overlapping – brings its own set of rules and precedents. The structure of each lease must meet your separate objectives in terms of law, taxes, accounting, and economic treatment. You must analyze a lease from each perspective independently to rule out conflicts because ‘true lease’ tests can be redundant, confusing or contradictory. More specifically, before you can even worry about SOX, all these elements must be fully under control.
The SEC is paying special attention to leasing, as mandated by Section 401c of SOX. In June of 2005, in its report on off-balance-sheet practices, the SEC identified lease accounting as an area in particular need of greater transparency. The Commission said that the FASB and the IASB should reconsider the current guidance on financial reporting for leases. Further, they proposed the possibility of ‘reporting all financial instruments at fair value’. These measures may be necessary, said the SEC, to eliminate the ‘bright line tests [that] have served to facilitate significant structuring of leases to obtain particular financial reporting goals’.
The report explains that current rules treat lease contracts as if either all or none of the performance occurs at the beginning of a lease. Therefore the balance sheet does not reflect the interest that both parties have in the assets, receivables and payables. Thus economically similar arrangements receive different accounting treatments. The impact of this policy shift is significant – of the 200 companies the SEC reviewed, 77 per cent have off-balance-sheet operating leases totaling $1.25 trillion.
The SEC set four goals for improving transparency:
For lessees, the conclusion is clear and imperative: the compliance environment is challenging, and new requirements may soon make it even more so. So make sure your leasing operations are compliant now. That requires both a thorough understanding of all the regulations, robust new control systems, and automation where appropriate.
SOX (sections 302, 401, 404, 801, 802, 803, and 906) puts a spotlight on the risks of decentralized or fragmented leasing processes. In an uncontrolled leasing environment, for example, renegade individuals can (and do) execute improper or fraudulent transactions and keep them hidden from the company’s financial stewards. SOX requires that you tightly supervise leasing with clear, documented policies, processes, controls, and authorizations. SOX demands, for example, that all financial reports include an internal control report; this is designed to ensure that the company’s financial data is accurate because the company has adequate controls in place to protect the data. Annual financial reports must also include an assessment of the effectiveness of those internal controls, and the company’s auditing firm must then attest to that assessment.
FASB/CICA require public disclosure of minimum lease payments. That means a lease and asset portfolio maintained in a dedicated information system. Depending on the asset classes, this may also include accounting details down to the debits and credits for each asset. Pulling all that together often takes considerable manpower without outside help. Worse, and all too often, it leads to the use of ad hoc tools (like custom spreadsheets) and undocumented processes.
SOX disclosure mistakes can be seriously costly; in fact, they can cost the CEO and CFO their jobs. If a CEO or CFO signs off on incorrect certification, they may be subject to a fine up to $1m and imprisonment for up to 10 years. If errors are committed willfully, the fine can be as high as $5m and the prison term can stretch to 20 years.
To lower the risk of fraud and to protect shareholders, SOX demands a firm accounting control framework. The Committee of Sponsoring Organizations (COSO) Enterprise Risk Management (ERM) Framework has become the generally accepted standard for evaluating an organization’s risk management processes. The ERM Framework is also a very useful tool for remediation under Section 404. It states its purpose as raising ‘risk and control consciousness’ throughout an enterprise. The Framework recommends all these capabilities as necessary for effective internal controls:
It is vital to simplify controls, mitigate risks and ensure compliance. The key to those objectives is automating the capture of essential information: portfolio data, reconciled documents across the leasing financial supply chain, asset-level lease accounting and reporting. Reduce data entry by integrating with your internal procurement systems on the front-end and requiring electronic invoices from your vendors for easy reconciliation. Finally, close the loop on your acquisitions and accounting by also reconciling internally with your G/L and fixed asset subledgers of your ERP software.
Complying with SOX is the goal of a SOX control remediation initiative. But, a myopic approach that only considers compliance represents a lost opportunity. Complying with SOX introduces the diligence required to improve financial performance. Compliance alone is a burden; compliance that results in improved financial performance is an investment. In our experience, through effective management, our clients have reduced costs, increased efficiency, and complied with pertinent internal and external authorities. They use the checklists above and apply the best practices we will discuss in subsequent articles. Above all, they have been successful because they have adopted this thinking: manage leases and assets like you would any investment portfolio (because that is what they are) – comply, analyze competing options for the best returns and be shrewd.