Reporting Changes for Leased Equipment Will Hit Private Manfacturers' Balance Sheets
By: Sarah O'Sullivan, Industry Week
A change is coming for private manufacturing companies: new accounting rules that will, on average, more than double the average liability balance.
The new lease accounting rules codified under ASC 842 have had major impacts on the accounting industry and resulted in material changes to many companies’ financial reports. And, although public companies have already adopted—and adapted to—the new rules, the January 1, 2022, effective date for private companies is quickly approaching.
For the first time, most operating leases are required to be presented directly on the balance sheet in the form of a right-of-use asset and corresponding lease liability.
While financial statement impacts were anticipated, LeaseQuery’s Lease Liabilities Index report reveals just how significant those impacts have been. The manufacturing industry, specifically, has seen an average liability increase of 2.5x after adopting ASC 842.
While on the surface, the impact of this may appear minimal—especially when compared to the average liability increases overall for private and public companies; 4x and 13x respectively—the reality is quite stark, particularly when considering the industry as a whole.
For one, the manufacturing industry is asset (and subsequently liability/debt) -intensive and started with a larger pre-adoption liabilities base balance.
This means that the increase reported by manufacturing companies has a significance in real dollars. The primary reason for the increase is due manufacturers’ frequent use of operating leases, which provide the opportunity to obtain critical fixed assets needed to support their business without the initial cash outlays that purchases require. With the adoption of ASC 842, the operating lease structure no longer provides an off-balance sheet benefit, as the majority of leases must now be capitalized onto the balance sheet.
Adopting the new rules is often a company-wide effort, and partners across multiple departments will need to collaborate to ensure success. This collaboration as well as ensuring that key stakeholders, such as executive management, are kept updated throughout the process can be the difference between a smooth transition and a rocky journey with surprise outcomes.
The results of the 2021 Lease Liabilities Index highlight several critical considerations for manufacturing companies as they complete their ASC 842 adoption, not all strictly related to accounting. These include:
Getting a Handle on the Lease Portfolio
Manufacturing companies have historically leveraged operating leases to supplement their production processes in a cost-effective way. Common examples of operating leases include: production equipment, forklifts, trucks and other vehicles, facility and warehouse space and technology equipment.
One of the themes heard from public companies that have already adopted the new accounting rules is that the effort to identify and compile the data for the entire lease portfolio was both more difficult and took longer than originally anticipated. Some leased assets are relatively easy to identify and manage, such as large facilities, corporate office space, major pieces of production equipment, etc. However, for many manufacturing companies with a large quantity of small dollar (and moveable) leased assets like forklifts and vehicles, there can be a greater challenge to track down all the assets and their lease contract terms.
Therefore, the impact adoption has on a company’s lease procurement and accounting process starts long before the final balance sheet numbers are even seen. Manufacturing companies of all sizes must plan enough time and resources to properly identify all their leased assets, ensure they have the critical terms needed to measure the new asset and liability balances and prepare for their first post-transition audit.
For some companies, this also means discovering and improving gaps in their current lease procurement processes to ensure the new accounting calculations can be sustained into the future as new leases commence or existing leases are modified.
A strategic way to kick off the implementation journey is to perform a full review of your current lease procurement activities focusing on ensuring the right decision makers are involved, the accounting team is timely alerted of new or changing lease arrangements and documentation is maintained and accessible.
Managing the Message
Adopting ASC 842 results in new asset and liability balances presented on the balance sheet as well as more extensive financial footnote disclosures. These additions to a company’s reporting have an immediate impact on the accounting department, but there are also several other departments that should be educated on what the changes will be so they can prepare.
For example, alerting the treasury department to the fact that the liabilities balance will be increasing will allow them adequate time to review the company’s debt covenant requirements to determine whether the new accounting will impact these covenant calculations. If the calculations will be impacted, management will want to consider how to mitigate those impacts, which could mean initiating discussions with lenders to make changes to contractual terms.
Other examples of stakeholders outside of the accounting department that will need to better understand the new accounting rules include executive management, investor relations and procurement. ASC 842 is the most significant change to lease accounting in several decades and communicating what those changes are and how they will be seen in the financial statements will be a key step in preventing surprises to other financial statement users. The new accounting rules have a minimal impact on the income statement, but for companies like those in the manufacturing industry that have large lease portfolios, the new asset and liabilities balances will likely stand out. By preparing and delivering internal training and messaging throughout the company, management can limit confusion and help the organization manage the message (internally and externally) of how ASC 842 impacts them.
Leveraging New Data
Complying with the new lease accounting rules means compiling or refining a company’s lease portfolio listing and documentation. Departments outside of accounting are able to use this information to their advantage. A more detailed lease listing provides management with a better view of their current lease arrangements by showing:
How many assets are leased
Where those leases are located
How much those leases cost
When those leases end
Procurement teams can use this data to identify opportunities for cost savings and strategize future lease procurement decisions. In addition, with the off-balance sheet benefit of operating leases going away, this is a good time for companies to take a fresh look at their lease portfolios and consider changing buy versus lease or operating versus finance (formerly capital) lease strategies.
Finance and planning teams can also leverage the lease portfolio listing used to support lease accounting. A centrally located and up-to-date detail of all leasing arrangements assists these teams to more efficiently and accurately create and manage forecasts and budgets and support cost variance analyses. Explaining how lease costs affect the bottom line is easier and faster to do when the data is at your fingertips.
Transitioning to the new lease accounting rules calls for committed resources and detailed project planning and it will directly impact a company’s financials. Companies are spending a lot of time accumulating the lease information needed to calculate the new asset and liability balances, but that effort can result in various benefits for an organization. Public companies in the manufacturing industry have already experienced the rise in liabilities directly related to transition to ASC 842, and their private company counterparts will soon see the same trends.
Sarah O’Sullivan is an accounting director at LeaseQuery, a purpose-built, CPA-approved lease accounting software solution for the most comprehensive regulatory reform in 40 years.