As a manufacturer, chances are good that you lease facilities. Chances are even better that you lease equipment from a third party. In both cases, there are big accounting changes ahead that will greatly affect your organization.
The new leasing accounting standard (ASC 842) is one of the most significant accounting changes in recent history. It fundamentally brings all leases, including operating leases, onto the balance sheet. It becomes effective for public companies in 2019 and for nonpublic companies in 2020, and it’s going to dramatically change financial statements. The time to prepare is now.
What’s Altogether New and What’s Unchanged
New in the standard is the requirement that entities follow a modified retrospective approach for leases. This means the required accounting changes will need to be presented for leases existing at the earliest comparative period presented in the financial statements. For manufacturers that share prior-year statements alongside their present-year statements, it means work must be done retrospectively.
For example, a nonpublic company that adopts the standard in 2020 and shows comparative financial statements would also need to show the effects of the new lease standard for 2019 in its comparative statements.
A few items, however, are not changing. The new standard keeps the existing GAAP model of having two types of leases—operation and finance (formerly known as capital leases). Although the new criteria for determining the type of lease for a lessee are similar to the old criteria, the determination now relies on greater judgment because the new criteria do not include bright lines.
For instance, in order to classify a lease as a finance lease, one of the following five criteria must be met:
- Ownership transfers at the end of the lease term.
- A bargain purchase option exists for the lease asset.
- The lease term, which does not commence near the end of the economic life of the leased asset, is primarily for the remaining economic life of the leased asset.
- The present value of the lease payments and the residual value guarantees is equal to or more than substantially all of the fair value of the leased asset.
- The leased asset has no alternative use to the lessor at the end of the term because of its specialized nature.
Clearly, some of the five criteria are straightforward, while others require greater judgment. If your organization meets one of those five criteria, the accounting for a finance lease will be mostly similar to the existing accounting for capital leases.
The accounting for operating leases, on the other hand, will be significantly different from prior GAAP. The new rule requires the lessee to place all operating leases with a duration of 12 months or more (including the likelihood of renewals) on the balance sheet. That’s done by establishing a “right-of-use asset and lease liability” on the balance sheet. The intent is that by the end of the operating lease term, the right-of-use asset and lease liability will be fully amortized to zero. Clearly, even with month-to-month leases, there’s no keeping the operating lease off your balance sheet.
What You’ll Want to Do Now
Manufacturers should prepare well before the effective dates by first asking questions of their service providers and lenders. Also, organizations can make certain accounting elections now—to help streamline the identification and classification of leases—that are in effect before the new rule’s effective dates.
Despite all leases going on the balance sheet, lease classification is still an important activity, primarily because the reporting of expense categories will be different on the income statements for operating and finance leases.
Finally, many manufacturers’ balance sheets will expand substantially with the recognition of the right-to-use asset and lease liability. The size and dollar amounts will be surprising. With this anticipated substantial increase, certain bank covenants in place may be violated, and covenants related to total liabilities and debt-to-equity ratios will be affected. Now’s the time for manufacturers to address covenant language and definitions in their loan agreements with their lenders.