Manufacturers: It’s Time to Implement the New Lease StandardJune 06, 2019
Manufacturers, have you given thought to how the new lease accounting rules will impact business? Don’t wait until the last minute…the new standards could have a material impact on your balance sheets.
Editor’s Note: On July 17th, 2019 the FASB proposed delaying effective dates for four key accounting standards (accounting for leases, credit losses, hedging and long duration insurance contracts). Check out our blog, FASB Proposes Delay in Major Accounting Standards for more information.
Manufacturing businesses typically lease a significant amount of assets — from plants and warehouses to furniture and operating equipment. But many closely held manufacturers haven’t yet given much thought to the new lease accounting rules. Waiting to the last minute could be a costly mistake, however.
Insight from Public Company Disclosures
Accounting Standards Update No. 2016-02, Leases (Topic 842), goes into effect for public companies in 2019 and private ones in 2020. However, public companies are generally required to disclose the effects of accounting standards that have been announced but not yet adopted, so we have some early warning signs.
Tech firm LeaseAccelerator recently studied disclosures about the anticipated effects of the new lease standard reported by the top 100 U.S. public companies between June 30, 2017, and May 31, 2018.
The study found that 81% of companies expect the new lease accounting rules to have a material impact on their balance sheets. These companies include several well-known manufacturers, such as Estee Lauder, McKesson, Nike, IBM, Microsoft and Apple. Most expect the effects on their income statements and cash flow statements to be limited, however.
Even more surprising is the finding that 15% of these public companies, within roughly one year of the effective date, were still uncertain about the potential impact of the lease standard on their balance sheets. Clearly, many companies have significant work left to do to comply with the changes. Hasty implementation decisions can lead to financial reporting delays and restatements.
Balance Sheet Effects
For a change to be considered “material,” it must be significant enough to influence the decisions of financial statement users, including investors and lenders. That’s certainly the case for companies with significant operating leases: The new standard will move operating leases with a duration of 12 months or more (including the likelihood of renewals) from the notes to the face of the balance sheet.
In a nutshell, lessees will add right-to-use assets and corresponding lease liabilities. The liability will be measured at the present value of the lease payments over the lease term, with the portion due within the next year recorded as a current liability. The asset will be based on the liability, adjusted for lease prepayments, lease incentives received and the lessee’s initial direct costs. The lease will gradually be “amortized” (or reduced) over the term of the lease. By the end of the operating lease term, the right-of-use asset and lease liability will generally be zero.
The lease standard is fairly straightforward — once the policies, procedures and systems are in place to identify and track your leases. For some manufacturers, that’s easier said than done. Regardless of your company’s size and level of sophistication, the implementation process generally follows these four steps:
1. Identify all lease and rental contracts. Create a schedule that summarizes the amounts, nature and terms of your contractual obligations. Look beyond the plant floor — for example, salespeople may drive leased vehicles, the finance department may lease accounting software and purchasing may rent its copiers. Lease contracts are seldom kept in a central location, especially if your company has multiple facilities and autonomous departments.
2. Evaluate technology requirements. Your current accounting software vendor may not have made the requisite updates to enable you to track relevant information about leases under the new standard. Ask your rep what’s changed in how the system tracks leases. It’s better to find shortcomings out early, so you can shop for a more sophisticated system, if necessary. If you have only a few simple leases to track, Excel may serve your needs effectively.
3. Educate financial statement users. Investors and lenders need to be prepared for any material changes that may be coming to your company’s balance sheet. Otherwise, they could be blindsided when you adopt the changes. Review your debt covenants — such as those based on your debt coverage ratio — and discuss expected changes with your banker.
4. Meet with an accounting expert. Our accounting and assurance team is ready to help manufacturers, both public and private, implement the new lease standard. We can help you every step of the way, including enhancing oversight of lease obligations after the implementation phase.