AI isn’t just for back-office efficiency anymore — it’s being used to police the bottom line. As tenants deploy automated tools to audit every line of their leases, lessors must modernize their own data stacks to stay one step ahead of the digital auditor.
Audit firms USE AI to audit contracts, including leases.
Although I am no longer working as a lessor, I hear that some leasing companies still rely on customers and their accountants not understanding the terms of their lease offerings. You may call it “the fine print” but it is items that enable erroneous off-balance sheet accounting, operating lease classification and asset and liability capitalization.
ASC 842 and IFRS 16a
It’s a whole new ballgame under ASC 842 and IFRS 16. Lease accounting is more complicated. All leases with terms of more than one year must be capitalized. Auditors are using AI to audit contracts, including both leases and service contracts involving the use of assets. See this article from the Wall Street Journal. The article says,” Testing is a key part of auditors’ assessment of company financial statements. Auditors are required to examine specific business transactions and financial documents to verify that they actually exist and are recorded and accounted for accurately.”
The change in lease accounting that requires all leases with terms longer than one year to be recognized on the balance sheet drastically shifts auditors’ focus. When operating leases were off-balance-sheet, there was less concern, if any, about the use of equipment included in service contracts, as those service contracts were also off-balance-sheet. There was also less concern about terms in a lease that may be considered lease payments, except for considerations for those payments in the classification test, because lease payments were expensed rather than capitalized for operating leases.
This means that any fixed payment (variable payments based on a rate or index are included, too) that a lessor can require a lessee to pay must be considered in lease classification and capitalized with some exceptions (out–of–the–money residual guarantees are not capitalized but are considered in the classification tests). It also means that one-year leases with renewal options may not be one-year leases if it is reasonably assured the lessee will renew.
The audit concerns are with bifurcating service contracts that involve the use of an asset, the lease term, the amount of lease payments and terms that in effect, create minimum lease payments.
Leasing as a Service
For service contracts that include the use of equipment, the customer must determine whether that use constitutes a lease (i.e., whether there is an identifiable asset and the customer controls its use). If the contract contains an embedded lease, the customer must bifurcate the equipment lease portion and apply the tests to determine whether the embedded lease must be capitalized. If the lease term is one year or less, it need not be capitalized. If the service contract includes renewal options, the lease term includes any renewals reasonably assured to be exercised. This is a judgment call, but if the conclusion is that the lessee is reasonably assured of renewing, the lease must be capitalized, assuming renewals that lengthen the lease term.
Lease Payments
Lease terms such as interim rents, restocking fees, penalties for failure to renew and onerous redelivery provisions are lease payments.
First Amendment Leases
Lease structures, often called first amendment leases, don’t allow the lessee to return the leased asset without paying a high fair market value (FMV) defined by the lessor, not an appraisal. When Googling first amendment lease, I got this AI generated definition that it got from a lease document ” First Amendment Lease means a Lease Contract in existence as of the Initial Closing Date which, pursuant to its terms (i) provides the applicable lessee Obligor thereunder the right to purchase the On-Lease Equipment at either (a) a fixed purchase option price, or (b) a price equal to the greater of a stated price or the then applicable fair market value (but not both (a) and (b)) and (ii) provides that if the lessee Obligor does not exercise the purchase option described in (i) above the lease shall automatically extend for a term and rental stated in the lease.” It is a lease structure that, in effect, does not allow the lessee to return the equipment without paying an excessive amount equal to the lessor’s FMV rather than the true FMV. The lessor relies on the lessee’s CFO’s inexperience, and, for small companies, they may not have a legal staff to review contracts.
Ethics
CFOs must be concerned, as ethical intent is implicit in the Securities and Exchange Commission and Financial Accounting Standards Board regulations, which are designed to ensure transparency in financial reporting. Lessors should be concerned with ethics, as the CLFP code of ethics requires the highest standards of conduct, including ethical business dealings and the avoidance of misleading statements.
Conclusion
The lessors I worked for were very concerned about relationships, reputation risk, and legal risks (FASB, SEC, UCC, and IRS regulations). We never built a product offering that depended on customers and auditors not understanding its true nature. We had nothing to worry about audits. I had one boss tell me he never wanted to see us named in a Wall Street Journal article exposing unethical business practices.
About the Author:
Bill Bosco is the President of Leasing 101, a lease consulting company. Bill has 50 years’ experience in the leasing industry. His areas of expertise are accounting, tax, financial analysis, structuring and training. He is a frequent author and speaker on leasing topics. He has received distinguished service awards from the ELFA and Monitor magazine as well as being inducted into the ELFA Hall of Fame. He was a member of the FASB Leases Project Working Group to help create ASC 842. He can be reached at wbleasing101@aol.com. See his website: https://leasing-101.net/
