Problems with Lessees' Leasing Operations - What About Your Company?
The leasing process at most companies does not garner the same amount of attention, resources or automation as other finance functions. As a result, corporate executives have little or no visibility into the leasing process. As stated in earlier articles in this series, the weaknesses associated with leasing operations include poor controls and accounting, decentralization with inadequate accountability, ineffective or inconsistent business processes, and incomplete information systems. The result of fragmented leasing operations is an increased probability of financial error or impropriety.
Consequently, mending leasing operations involves overcoming challenges of expertise, policy, process, technology and corporate politics. This article looks at common problems faced by medium and large corporates and analyses their origins and significance. This will enable corporates to evaluate the gap between current standards and the reality inside the company. Subsequent articles will discuss best practices and the benefits of instituting them.
Many finance executives lack the visibility, controls, resources and reporting needed to attend to their leasing operations, resulting in suboptimal economics, cost leakage and compliance exposure. Most problems related to leasing operations involve problems of omission – information inadvertently excluded – because financing capital expenditures is typically viewed as an ancillary function in corporate finance. In most companies, leasing is a decentralized activity lacking any universal controls. In some companies, the financing model does not align effectively with the business strategy. Accounting details for each transaction are often either inaccessible or widely distributed over many spreadsheets. Transactions lack traceability. Often, the lack of standardization and error-checking leads to poor data quality and unusable reports. Consequently, finance executives often have no idea who is leasing what to whom, lack the confidence that the right decision-making process is in place for incremental financings, and do not have the information required to measure and communicate effectively. In some cases, employees actually have purchasing authority but are unclear about company financial requirements regarding capital expenditures and authorization rights. Less frequently, leasing is managed by a specific department, such as IT, without a clear financing strategy.
Decentralized management and fragmented systems translate to disarray in controls and compliance management. Policies, procedures and controls tend to be poorly designed, incomplete, and unclear – yielding an environment in which opportunistic individuals pursue inappropriate transactions not in the company’s best interests. At its worst, these individuals intentionally bypass budget limits through financing. In many situations of this sort, financing decisions are based upon personal relationships rather than shrewd economics. Costly errors may result from this situation. Questionable off-balance sheet structures, for example, could lead to unreliable financial reporting, which is the type of problem that internal controls can help companies avoid.
Let’s start with you – the lessee ‘finance executive’. In companies of all sizes, leasing lacks executive attention and visibility. Quite often, leasing transactions ‘just happen’ with no overarching strategy or policy. Because leasing has grown organically based on local relationships, management of the leasing process is decentralized and executives do not know who is leasing what with whom. Those employees actually executing the leases may be unclear about the extent of their authority. As a result, finance executives are not confident that the incremental decision-making about economics and the terms and conditions of transactions are being carried out properly.
A company that has a decentralized financing process for capital expenditures, lacks controls, and is not automated restricts the effectiveness of executives. The company’s executives will not receive the information necessary required to:
Most lessees do not manage their lessor relationships effectively. Typically, this results from a leasing financing model that does not fit the business strategy. For example, lessees may have an exclusive relationship with one large lessor based on convenience, ultimately resulting in monopolistic rates and terms. Others may use 30 or 40 different lessors, each with different terms in the master lease agreements (MLAs), resulting in a higher cost of capital, poorly negotiated terms and conditions, and unnecessary inefficiency, complexity, and administrative costs. Problems with the lessor-lessee relationship, the lessor model, and transaction economics are interrelated and may result from a lack of expertise, experience, or interest on the part of whoever is negotiating agreements. They may also result from the lack of sufficient time and resources required to successfully manage the process. Poor management of the financing relationship can lead to a host of problems, including:
A common symptom suffered by many companies is poor transaction execution. If nobody is charged with regularly and thoroughly performing FASB 13 tests (and documenting/archiving the math) at the time of transactions, for example, off-balance sheet transactions can be called into question. Even when a trusted expert within the company performs the financial calculations and determines that a transaction passes the FASB 13 test, if the other terms of the transaction do not substantively support the lessor’s ownership and economic risk, an auditor can force a company to recognize the transaction on their balance sheet. For example, a lessor can require that equipment be returned in its original packaging – how realistic is that? In addition, poorly tracked and managed documentation can result in significant cost leakage. For example, if the line items on purchase orders, invoices, and the certificate of acceptance are not properly reconciled at the time of the transaction, a lessee might overpay unwittingly.
When managing individual assets throughout their lifecycles, as well as managing the entire lease portfolio, several critical problems are endemic in companies. Assets are often encoded incorrectly (e.g. serial number, general ledger code, business unit, legal entity, cost center). Assets can also be misclassified, leading to complications in accounting, tax and budgeting; inappropriate disclosure on financial statements; and significant exposure issues with lessors and external authorities. If the lessee upgrades or moves the asset to another location and does not disclose these changes to their lessor, the lessee will probably not be complying with their MLA and have tax exposure from the change in jurisdiction.
Many companies depend on their lessors to document transactions, calculate taxes and payments correctly, and provide reports. Several problems arise with this approach to portfolio management. If a lessor makes a mistake in their calculations, it could result in the company overpaying for the lease or underpaying the taxes, both of which would not be internally controlled. If the lessor is performing the reconciliation of the purchase order (PO), invoice or certificate of acceptance, the lessee is subject to the discipline and quality controls of each lessor. If the lessor makes a mistake, the lessee suffers the exposure, resulting in overpayment, underpayment, or paying for something not received. If a lessor does not provide easy access to all of the documents and data related to the transaction, it becomes difficult for the company to develop compensating internal controls and the transaction is then fundamentally unauditable. If a company uses multiple lessors, it must then access the stovepipe system of each lessor to aggregate and report their overall portfolio. Within the lessee’s organization, no centralized source for all leases and assets exists, as each lessor uses different systems, creating undesirable complexity and bureaucracy for the company’s treasury, controllers, business users, and auditors.
Many companies encounter problems because they cannot access necessary information. On the one hand, some lessees rely on their lessors to provide them with the information they need, only to find that there are severe limitations with the lessor’s systems. Typically, the lease accounting system of lessors only records transactions at the schedule level because it is necessary only to track the basic financial terms of the lease (such as original cost, lease rate, date and term) in order to send the bill. On the other hand, some lessees generate schedule level information internally and capture it in the general ledger. In this case, the information is created with a scenario similar to this:
In either case, schedule level information is insufficient for controlling the leasing process and ensuring compliance inside a lessee. For example, when an asset is moved, lost, or damaged and these changes are undocumented and undisclosed, a lessee may not be in compliance with their MLA or can face sales and/or property tax exposure. If there are any interim events, such as a partial buyout, either the lessee will have to depend on the lessor’s calculation (which was done by hand outside of their ‘schedule-based’ lease accounting system), make a change to their general ledger without the ability to back up the calculation with the proper asset detail or the change will simply not be reconciled properly with the general ledger. Moreover, if the lessee does not properly manage organizational changes, such as reorganizations, mergers, and acquisitions, assets and lease payments can be misassigned or misallocated, or overlooked, resulting in problems with internal budgeting, profit and loss analysis, and balance sheet integrity.
Finally, the poor management of the end-of-term of the lease or the end-of-life of the asset – especially its disposition – may result in significant risk exposure and economic loss. Most lessors make their money at the end of term. In a decentralized leasing process with poor controls and documentation, it is easy to miss required end-of-term notifications, resulting in automatic extensions or renewals, penalties, and overpayment. Even if a lessee executes the required notification and chooses to pay the fair market value at the end of a lease, if the lessee does not have the resources to negotiate that fair market value, the lessor will demand and receive terms that are favorable to them – sometimes at extreme, abusive rates. Also, lessees that buy some or all of the assets at the end-of-term and fail to perform the proper inventory accounting may face audit and compliance challenges. Furthermore, there are many state and local regulations designed to address environmental pollution, data security, and data privacy (reviewed in an earlier article). If a leasing operation does not adhere to the rules, both individuals and the company could be exposed to punitive measures that could include imprisonment.
Many modern companies suffer from fragmented systems, such as homegrown software applications created to solve narrowly defined problems. Microsoft Access databases created to track key lease terms, third party ERP systems, asset management software, and ad hoc spreadsheets are by far the most prevalent. The fragmentation may result in the following:
Process and system fragmentation and missing automation result in redundant data entry, poor data quality and integrity, and insufficient data security – all of which reduce productivity. This breeds a challenging decision-making environment, as the reporting and analytics are then inconsistent and the data suspicious, serving to further degrade company performance.
Many firms run their leasing operations on spreadsheets. This involves checking and rechecking homegrown financial calculations, considerable maintenance and, because of errors or omissions, constitutes a source of risk. Spreadsheets alone do not work. Spreadsheets also fail to provide executives and stakeholders with insight into operational performance or control risks that could result in financial restatements or fraud.
As mandated by SOX and other related standards, public company executives must evaluate the effectiveness and efficiency in their capital expense finance/leasing process and, furthermore, provide reasonable assurance relating to the business’s achievement of objectives. Those executives who fail to address the operational and automation requirements of their leasing process may be at risk.
One of the most significant thrusts of recent corporate legislation is the clear accountability of individuals for their decisions and actions. Poorly designed, incomplete or unclear policies and processes, technology systems, internal controls and audit procedures for leasing operations create ambiguity and a vacuum of accountability. These conditions may foster a climate of irresponsibility or fraudulent activity. Under these conditions, management has only limited visibility into company leasing operations at best. This can lead to the intentional dodging of budget limits, such as transactions driven by personal relationships with lessors rather than objective financial motivation, failure to comply with laws and agreements, and in the worst cases, fraud and embezzlement.
Sole accountability then rests with the CFO and CEO. Historically, a company’s executives have only been required to disclose their five-year minimum lease obligations in the notes of their public financial statements, enabling them to properly account for capital and operating leases on their balance sheets. By contrast, today’s executives must also evaluate their internal controls, audit procedures, governance, and ethics in their capital expenditure financing process, then update them to ensure SOX compliance, and disclose any material risks or failures to comply. Executives will face risks if they are not able to track and trace every person, event, document and asset, or if they cannot monitor all related communications for on balance sheet or off balance sheet lease transactions, provide lease accounting at the asset level fully reconciled with their general ledger, and demonstrate the reliability of their financial reporting. Inability to follow these procedures could result in material deficiencies or non-compliance, and the potential for litigation, fines and imprisonment.
The next article in this series will discuss the best practices that you can bring to your firm to avoid these problems and improve the financial performance of your leasing operations.