Manufacturers & Distributors Lease Accounting Standards Considerations
Contributed by William G. Godfrey, III, CPA, Senior Manager at Holsinger P.C.
Privately-owned companies reporting under Generally Accepted Accounting Principles (“US GAAP” commonly requested by banks) are required to adopt the new lease standard effectively January 1, 2022. This can create some significant challenges as owners, bankers, controllers, and other financial statement users are now expecting to see Right of Use (ROU) assets and ROU liabilities on their balance sheets, present value calculations using a discount rate, and new footnote disclosures.
Often, manufacturers and distributors have unique arrangements for service agreements and contracts that may trip the requirement to account for leases under FASB ASC 842, even if the contract does not explicitly state it is a lease. Controllers should take inventory of leases and contracts in order to identify the potential impacts on covenants and accounting. We often see manufacturing and distributors with leases surrounding:
1.) Factory / Building
2.) Warehouse or Office Space
5.) Related party agreements with owners or entities under common control
6.) Land or Property
7.) Shared labor / Workforce
1. Leases will be classified as either operating leases or finance leases (formerly capital leases). Previously, operating lease payments were expensed as rent through the income statement.
2. All leases, not considered short-term (see practical expedient), must be recorded as assets and liabilities on a company’s balance sheet. A right-of-use (ROU) asset and a lease liability will be recorded based on the present value of the future lease payments.
3. Companies with financial statement footnote disclosures, will need to add details on discount rate, variable considerations, assumptions, and restrictions.
Financial Statement Impacts
Operation & Financing
Single lease costs, typically on straight-line basis
Interest expense (effective interest method) and amortization expense presented separately
Statement of Cash Flows
All payments flow through operating activities
Statement of Cash Flows
Interest and variable lease payments in operating; amortization of principal in financing
Embedded leases - The new lease standard includes the concept of an “embedded lease.” Within service or supply contracts, there may be specifically identifiable assets that are dedicated to the lessee for a set period of time.
Balance sheet changes- Balance sheet and income statement changes may highly affect financial ratios and may change the results of financial covenants – including those typically associated with asset-based lending. ROUs will be classified as long-term assets, with the corresponding lease liability being separated into current and long-term liabilities.
An early start for evaluation of these financial covenant impacts and continued communication to lenders will go a long way in preventing year end reporting delays. Lenders may consider either amending items such as: terms and definitions, the financial covenant components; or adjust the ratio requirements as a reaction to the changes from lease accounting.
Beyond the classification of leases as finance or operating, some other challenges in implementing the new lease standard include the selection of the appropriate interest rate for calculating the present value of the lease payments, determining lease versus non-lease components, evaluating renewal terms and leasing agreements with related parties, and selecting practical expedients for implementation.
We strongly encourage manufacturers consider which practical expedients they can adopt to ensure proper implementation and less compliance costs. This article is but a summary of some of the key provisions in the new lease standard.
This information is not meant as tax advice but merely an informative piece. Holsinger, P.C., is a Certified Public Accounting firm providing professional services, including accounting, tax, financial advisory and consulting services, to a wide range of privately held companies, public sector organizations and high-wealth individuals. The firm serves clients locally and globally from its Pittsburgh headquarters. For inquiries or more information, please visit our website www.holsinger.cpa or email us at email@example.com .