Calendar-year companies that are privately-owned are required to adopt new lease accounting rules beginning January 1, 2022. These new accounting rules will impact nearly all entities utilizing U.S. GAAP; however, manufacturers may be impacted the most.
Under the new guidance, U.S. GAAP entities with operating leases are now required to calculate and record the present value of their future obligations under operating leases as a liability with the debit-side of the entry recorded as a right of use asset on the balance sheet. Although this accounting may seem straight-forward, certain challenges exist for manufacturers as it relates to the adoption of this new guidance.
Operating Lease Identification
One challenge relates to the identification of operating leases. Manufacturers often engage in unique service agreements with vendors in order to fulfill specific aspects of its business. And, without knowing, the entity may have entered into a contract with a vendor that contains a lease. These agreements may not be titled, or use the word, “lease” within the document, or may not otherwise be thought of as a lease.
The new rules state that a contract is or contains a lease if the contract conveys the right to control the use of identified property, plant, or equipment for a period of time in exchange for consideration. Although this definition is similar to the definition of a lease under previous guidance, it is now more crucial that all leases be identified since future lease expenses are now capitalized on the balance sheet instead of only being reported in a footnote disclosure.
Agreements should be reviewed to determine if identified property, plant, or equipment is utilized by the vendor as part of the service being performed. If identified assets are being utilized by the vendor, the agreement contains a lease and should be included in the operating lease liability recorded on the balance sheet.
The identification of leases may call for additional internal control processes. Most privately owned companies don’t have controls in place to review vendor contracts for the purpose of identifying lease arrangements as an accounting matter. Unless additional controls over the review of vendor contracts are put in place, it is likely that these lease arrangements will not be identified, leading to a misstated balance sheet.
Additional complications for manufacturers relate to expected lease renewals. Manufacturing facilities often require significant investments in building improvements in order for the facility to handle capital intensive operations. An entity would need to consider the period used for amortization of leasehold improvements consistent with the lease term used to calculate the operating lease liability. Privately owned manufacturers often lease their manufacturing facilities from related individuals, or entities under common control, frequently without a written lease agreement, or under a short-term agreement. In these cases, the new lease standard requires the lessee to consider the term of the lease including renewal periods that are “reasonably certain” to be exercised. In cases where lease terms are month-to-month, or are short, the manufacturer would likely not be able to justify amortizing leasehold improvements over a longer period of time than what is used as the lease term for purposes of calculating the lease liability.
Questions? Have a Barnes Dennig team member reach out to you to discuss lease accounting and it’s impact on your business. You can contact us here anytime or give us a call at 513.241.8313.