New lease accounting rules will move operating leases onto the balance sheet. Public companies started using Accounting Standards Update No. 2016-02, Leases, at the beginning of this year. Private companies must apply the updated guidance for fiscal years beginning after December 15, 2020 (2021 for calendar-year companies), and for interim periods within fiscal years beginning after December 15, 2021.
The deadlines for private companies include a one-year deferral. This summer, the Financial Accounting Standards Board (FASB) unanimously agreed that a delay in the implementation deadlines would be beneficial for private companies. Many businesses told the FASB that they were not ready to implement the lease standard, because they were struggling with resource constraints and insufficient technology expertise in setting up internal systems after having to adopt revenue rules.
Based on feedback from public companies, implementing the updated lease standard can be expensive and time-consuming. So, even with a one-year reprieve, private manufacturing companies should start the implementation process as soon as possible.
Lease accounting 101
Under current U.S. Generally Accepted Accounting Principles (GAAP), private companies classify leases two ways.
- Capital (or Finance) Leases
Under these types of financing arrangements, ownership of the underlying asset is transferred to the lessee at the end of the term. These are reported on the lessee's balance sheet.
- Operating Leases
These off-balance-sheet arrangements provide rights to use the underlying asset during the lease term. They must be disclosed in the financial statement footnotes.
The updated guidance requires leases with terms of at least one year to be reported on the balance sheet. The lessee records a "right of use" asset — generally equal to the minimum payments under the lease, discounted to present value — as well as a liability reflecting its obligation to make those payments. The new rules maintain the distinction between operating leases and capital leases, which affects expensing of lease-related costs.
A contract contains a lease if it conveys the right to control the use of an identified asset for a period of time. The term "control" refers to the right to direct the use of the asset and to obtain substantially all resulting economic benefits.
A major challenge under the updated rules is identifying "embedded" leases in other types of contracts, including certain service contracts and contract manufacturing arrangements. For example, a transportation contract may provide exclusive rights to, and control over, a specific vehicle or fleet of vehicles. Under the updated guidance, companies will need to separate lease and non-lease components of these contracts and provide detailed disclosures.
Implications for manufacturers
Do you have significant operating leases for facilities, warehouses, equipment, vehicles and other assets? If so, evaluate the impact of the new lease accounting rules. When they take effect, you will see an immediate increase in assets and liabilities on your balance sheet. This can make your company appear more leveraged than before, affecting the way investors and lenders view your financials.
Moving leases to your balance sheet may also cause technical violations of loan covenants that limit your debt or require you to maintain certain debt ratios. It is important to discuss the effects of the new accounting rules with your lenders to minimize surprises when you deliver your financial statements and, if appropriate, to negotiate amended loan covenants.
Next steps
Before the new lease accounting rules take effect, review your contracts to determine which ones are leases — or contain leases. Then evaluate your accounting systems, processes and internal controls to ensure that you are prepared to track and record the necessary data for both reporting and disclosure purposes.
The new rules expand the types of information you will need to gather and the calculations needed to determine lease values and expenses. To simplify matters, you may want to explore lease management software that automates the process.
Need help?
Most private manufacturers expect to spend significant time and effort to comply with the new lease accounting rules. Contact an accounting professional for implementation guidance.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
