Manufacturing and Distribution Group Newsletter – Spring 2017
Kenneth Tornheim

Leases and Contract Revenue: Get Ready to Roll Out the New Accounting Standards


Two major accounting rule changes will soon go into effect and they are expected to have major impacts on how many manufacturers and distributors report their financial results. Here are the details, including what is changing, when the changes must be implemented and how they will affect financial statements.

A New Lease on Leases

Of the two updates discussed here, the changes to lease accounting are much more straightforward. In fact, the Financial Accounting Standards Board (FASB) did not even assemble a transition resource group to help companies implement the updated lease guidance.

In a nutshell, Accounting Standards Update (ASU) No. 2016-02, Leases, requires operating leases with terms longer than a year to appear on the lessee’s balance sheet. As a result, manufacturers and distributors will report leased warehouse space, vehicles, equipment and other property as right-to-use assets, along with the rent they owe as liabilities.

The existing lease accounting rules in U.S. Generally Accepted Accounting Principles (GAAP) require companies to record lease obligations on their balance sheets only when the arrangements are similar to financing transactions, such as rent-to-own contracts for buildings or vehicles. So, operating leases are not reported on the balance sheet under existing GAAP.

This fundamental change in financial reporting will make lessees appear more leveraged than they did in the past, even if the company’s day-to-day operations have not changed. In some cases, the new standards will cause companies to violate loan covenants, requiring them to obtain waivers from lenders or renegotiate financing terms to reflect higher debt ratios.

For public companies, the updated lease accounting standard goes live in 2019. Private companies have an extra year to comply. Companies that issue comparative statements will need to start collecting data to implement the changes well in advance of these deadlines.

Major Changes to the Income Statement

The changes to revenue recognition under ASU 2014-09, Revenue from Contracts with Customers, are far more complicated than the updated lease guidance. The new revenue recognition update replaces about 180 pieces of industry-specific guidance in GAAP with a broad, principles-based method for most businesses to recognize revenue. (See “Five Steps to Recognize Revenue” below.) This new approach to revenue recognition is more closely aligned with international financial reporting rules.

The changes will be significant, especially for manufacturers and distributors that enter into specialized, long-term contracts with customers. For some companies, the updated guidance will result in earlier revenue recognition than in current practice. This is because the new standard will require companies to estimate the effects of sales incentives, discounts and warranties. The new standard also provides guidance on service revenue and contract modifications.

Nearly all manufacturers and distributors will need to beef up their footnote disclosures under the new rules. The update requires detailed breakdowns of revenue by product lines, geographic markets, contract length, services and physical goods.

The revenue recognition guidance goes into effect a year before the lease standard. It is effective for public companies in 2018 and private companies in 2019. In December 2016, the Securities and Exchange Commission (SEC) estimated that 22% of public companies had not started implementing the revenue recognition standard guidance and that statistic is likely higher among private firms.

Proactive manufacturers that have started the implementation process forewarn of the challenges. Last November, Christine DiFabio, assistant controller at Zoetis, a manufacturer of animal medicines, said during a panel discussion at Financial Executives International’s Current Financial Reporting Issues Conference, “For those people who haven’t started or are very early, try to start to speed it up, because while you may not think it will have a significant impact financially, it is a significant impact in workload and documentation efforts as well.” She described the accounting change as “all encompassing.”

Michael Cleary, Boeing vice president of accounting and financial reporting, also acknowledged during the panel discussion that the changes under ASU 2014-09 would significantly alter when his company records revenue. Boeing’s customer contracts are typically long-term and complicated, so he formed a steering team, including officials from the communications and human resource departments, tasked solely with implementing the new standard.

Need Help?

With the implementation deadlines for the updated lease and revenue recognition standards fast approaching, it is time to review your contracts. That is the first step in implementing the changes. The next step is to contact your CPA to understand how the changes will affect your company’s financial statements in the future.

Sidebar: Five Steps to Recognize Revenue

Accounting Standards Update (ASU) No. 2014-09 will require companies to follow five steps when deciding how and when to recognize revenue:

  1. Identify a contract with a customer;
  2. Separate the contract’s commitments;
  3. Determine the transaction price;
  4. Allocate a price to each promise; and
  5. Recognize revenue when, or, as the company transfers the promised good or service to the customer, depending on the type of contract.

The updated guidance will require companies to exercise more judgment when recognizing revenue than do the existing rules. An accounting professional can help you make informed judgment calls based on the terms of your customer contracts.

For more information, contact Ken Tornheim at [email protected], or call him at 312.670.7444. Visit ORBA.com to learn more about our Manufacturing and Distribution Group. Visit ORBA.com to learn more about our Manufacturing and Distribution Group.


Do Not Overlook the Domestic Production Activities Deduction

The domestic production activities deduction (DPAD), also commonly referred to as the manufacturers’ deduction or Section 199 deduction, provides a generous tax deduction for certain “domestic production activities.” Unfortunately, many taxpayers overlook this valuable tax break because they believe this deduction is only available for manufacturers.

In fact, the deduction is available to a wide range of businesses, such as construction companies, architects, engineers, software developers, oil and mining companies, agricultural processors and producers of recordings and films. If a taxpayer has yet to explore the tax savings opportunities under DPAD, the time is now. It is also a great time for taxpayers to revisit the DPAD due to temporary and proposed regulations that may affect their eligibility.

Significant Benefits

It is not uncommon for a taxpayer to avoid taking advantage of certain tax benefits because they are intimidated by the rules and do not even know where to start. It would not be right for this article to make claims that this calculation is easy. In fact, calculating the DPAD can be very complex. Generally speaking, the DPAD is equal to 9% (6% for “oil related” activities) of the lessor of:

  • Qualified production activities income; and
  • Adjusted gross income figured without the DPAD.

In addition, the DPAD cannot exceed 50% of the W-2 wages for the year that are attributable to the qualified production activities.

Qualified production activities income is the excess (if any) of domestic production gross receipts, over the sum of:

  • Cost of goods sold allocable to the domestic production gross receipts; and
  • Other expenses, losses or deductions that are properly allocable to the domestic production gross receipts.

IRS Offers Guidance

Recently, there are temporary and proposed regulations that clarify a number of issues related to the application of the DPAD. Here are some of the highlights:

  • Contract Manufacturing
    When calculating the DPAD, a taxpayer might run into a situation where part of their production activity is contracted to an outside third party. Which party involved in this contract manufacturing arrangement is entitled to claim the DPAD? Under the current rules, the answer depends on which party enjoys the benefits while bearing the burdens of ownership over the related manufactured property. There are several factors to be considered when making this determination, such as:
  • Which party retains legal title to the manufactured property during production?
  • Which party controls the property and the process?
  • Which party bears the risk of loss or damage?
  • Which party receives profits from the property’s sale?
  • Which party pays property taxes?

To eliminate the uncertainty associated with this complex analysis, the proposed regulations would establish a bright-line test under which the party that actually performs the activity would be entitled to claim the deduction.

  • Construction
    Qualified production activities include those associated with the construction or substantial renovation of U.S. real property. Currently, this includes those activities typically performed by a general contractor, such as management and oversight of the construction process. The proposed regulations would clarify that a contractor whose activities are limited to approving and authorizing invoices and payments is ineligible for the DPAD.
  • Testing and Packaging
    Under the current rules, qualified production activities may include the testing of component parts, packaging and repackaging, labeling and minor assembly. The proposed regulations would exclude these activities if the taxpayer is not otherwise involved in manufacturing, producing, growing or extracting the property in question.
  • W-2 Wages
    The current temporary regulations provide guidance on the application of the W-2 wage limitation to taxpayers with a short taxable year. Typically, wages are calculated on a calendar-year basis. There has been some uncertainty over the treatment of wages paid during a short tax year that do not include a calendar year end (meaning W2s have not been issued). These temporary regulations provide that wages paid to employees during such a short tax year are included for the purposes of the W-2 wage limitation. The temporary regulations also clarify the treatment of wages when a business is acquired or disposed of during the year. If employees receive wages from two different taxpayers, those wages are allocated between the taxpayers based on the employees’ respective periods of employment with each taxpayer.

DPAD Revisited

If you have claimed the DPAD in the past, or if you think your company may qualify in the future, talk to your tax advisor about how the temporary and proposed regulations will affect your eligibility and the size of your deductions.

For more information, contact Amy Jackson at 312.670.7444. Visit ORBA.com to learn more about our Manufacturing and Distribution Group.

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