After several postponements, the updated lease accounting standard Accounting Standards Update (ASU) 2016-02, Leases (Topic 842) is in effect for private companies. Late last year, the Financial Accounting Standards Board (FASB) voted unanimously against another delay. That means companies that follow U.S. Generally Accepted Accounting Principles (GAAP) must adopt the new standard for fiscal years beginning after December 15, 2021 (Calendar year 2022).
Related Read: Topic 842 Basics for Lessees
In a nutshell, the updated standard requires companies to report both operating and finance leases on their balance sheets (with the exception of short-term leases with terms of 12 months or less). Previously, operating leases did not have to be recorded on the balance sheet. Pursuant to the updated standard, a lessee under an operating lease must record a “right-to-use” asset and a corresponding liability for lease payments over the expected term. Generally, the asset and liability are based on the present value of minimum payments expected to be made under the lease, with certain adjustments.
It is not unusual for manufacturers to have a significant number of operating leases for buildings, equipment, vehicles, technology and other assets. As a result, the updated standard, when adopted, will immediately increase your company’s assets and liabilities, making it appear to be more leveraged than before. This can cause technical violations of loan covenants that limit your debt or require you to maintain certain debt ratios, so it is important to discuss the standard’s impact with lenders and, if necessary, negotiate amended loan covenants.
For many manufacturers, the biggest and most time-consuming challenge will be to locate all of your leases and extract the data necessary to comply with the updated guidance. Leases generally are not standardized, so reviewing them and gathering the required data can be a labor-intensive, manual task. You will need to capture and analyze dozens of data elements, including lease terms, payment schedules, end-of-term options and incentives. Complicating things further, some of the data you will need may not be found in the lease itself, so additional legwork may be required.
Another challenge will be identifying leasing arrangements that must be accounted for under the updated standard but are not found in traditional lease agreements. If an agreement gives you the right to control an identified asset for a period of time in exchange for payment, then it will be considered a lease under the updated standard.
These “embedded” leases may be in service, supply, transportation or information technology agreements, as well as in certain contract manufacturing arrangements. For example, if a transportation contract gives you exclusive rights to, and control over, a specific vehicle or fleet of vehicles, you may need to treat it as an embedded lease and separate the contract’s lease and nonlease components for reporting purposes.
Lease accounting software
Locating leases (including embedded leases), gathering data and analyzing that data for lease accounting purposes is a lot of work. To ease the burden, lease-intensive companies should consider using lease accounting software to automate the process of managing and tracking their leases and calculating their lease-related assets and liabilities. Contact your ORBA CPA to find out more.
For more information, contact Ken Tornheim at [email protected] or 312.670.7444. Visit ORBA.com to learn more about our Manufacturing and Distribution Group.