How New Lease Accounting Rules Can Impact Manufacturing Companies
Private companies will have to comply with the new lease accounting standard for fiscal years that begin after December 15, 2021. The standard, ASC 842 was issued by the Financial Accounting Standards Board (FASB) in 2016. Private companies were given a one-year extension due to COVID-19, but the standard is now effective.
Companies with operating leases with terms of 12 months or less will now be required to record those on the balance sheet, whereas before, they only had to record assets and liabilities for capital leases. The adoption of the new guidance could present challenges for manufacturers.
Challenges of Operating Lease Identification for Manufacturers
Rule ASC 842-10-15-3 states that “a contract is or contains a lease if the contract conveys the right to control the use of identifies property, plant or equipment (an identified asset) for a period of time in exchange for consideration.” This new definition varies slightly from the previous guidance but is more essential now that all leases will be identified since future lease expenses will be capitalized on the balance sheet rather than being reported in a footnote disclosure.
One challenge manufacturers’ might face is identifying if they have operating leases. When manufacturers engage with their vendors in uncommon service agreements to fulfill aspects of their business, they could have unknowingly enrolled into a contract that contains a lease due to agreements not mentioning the word “lease,” being titled as a lease or thought of as one. All agreements with vendors should be reviewed to determine if by definition the agreement contains a lease and if it would need to be recorded as an operating lease liability on the balance sheet. Many privately owned companies do not have controls in place for someone to review vendor agreements. This means that misstated balance sheets could occur due to lease arrangements not being correctly identified.
Additional Complications for Manufacturers Adopting the New Lease Accounting Rules
Expected lease renewals are another complication for the manufacturing industry. For manufacturing facilities to handle capital operations, investments in building improvements are required. For an entity to calculate the operating lease liability, they would need to consider the period used for amortization of leasehold improvements.
Usually, privately owned manufacturers lease their facilities from entities under common control or related individuals without having a written lease agreement. In this case, the new lease standard would require the lessee to consider the term of lease which includes renewal period that are “reasonably certain” to be exercised. In month-to-month, or short-term lease agreement cases, the manufacturer would not be able to justify amortizing the leasehold improvements over a longer period of time, unless also treating the lease as a long-term lease to calculate a right-of-use asset and related liability.
If you have any questions about the implementation of the new lease accounting standard and how it can affect manufacturing companies, please contact a Brown Plus advisor.