2022 may very well be the year of balance for manufacturers, and for private manufacturers, balance sheets.
As the industry continues to address ramifications from pandemic-related supply chain disruptions, inflation concerns, and other market factors, another development has arrived with a balance sheet impact: changes to lease accounting guidance. The Financial Accounting Standards Board (FASB)’s updates to lease accounting will require companies that lease assets – such as heavy machinery and equipment, to record all long-term leases on their balance sheets starting in 2022 for calendar year-end private manufacturers.
Below are the core provisions manufacturers should know about with the lease accounting changes and how the standard could potentially affect your financial statements.
What is ASC 842?
The FASB introduced ASC Topic 842, Leases, to increase transparency into the lease accounting for public and private organizations. The new lease guidance went into effect in late 2018 for public companies and, after several extensions, finally went into effect for most private companies for fiscal years beginning after Dec. 15, 2021.
The new ASC 842 lease accounting standard requires organizations to record all leases on their balance sheets except for those meeting the short-term lease criteria. The goal of the change is to provide a more accurate picture of an organization's financial health and offer a better understanding of its financial commitments.
The changes affect everything from financial statements to the lease cataloging process.
How will ASC 842 Affect Manufacturing?
ASC 842 contains guidance for companies that manage leases (lessors) and companies that lease assets (lessees). Manufacturers are most likely to find that the lessee accounting guidance is the most applicable to the leases that they use in operations.
The lessee accounting guidance classifies a lease as either a finance lease or operating lease. Finance leases and operating leases have slightly different financial reporting requirements for both income statements and balance sheets. Changes brought about by the new standard may mean that manufacturers with operating leases are having to record lease assets and liabilities for the first time on their balance sheets, which could affect lending arrangements and other scenarios that rely on balance sheets as inputs.
Cataloging all of the leases that your organization has and their corresponding lease type will be an essential part of your ASC 842 adoption efforts. Each lease may have both lease and nonlease components that will have to be separated for financial reporting purposes.
To record the lease assets and liabilities on your balance sheet, you will need to record the present value of future lease payments, which may be easier said than done. The accounting guidance requires that lessees use the rate implicit in the lease, if readily available, to determine the present value.It is expected that the implicit rate will not be known by many lessees; however, scenarios exist where the rate is known by the organization making its use a requirement. The alternative is to determine the appropriate incremental borrowing rate — the rate the lessee would pay to borrow on a collateralized basis of a similar term in a similar economic environment — adjusted for the length of the lease and the country or region of operation. Private lessees can also elect a risk-free discount rate accounting alternative for all or a select class of underlying assets.
Lease modifications and renewals will also be important to monitor with the new standard.
Leasing ‘Oddities’ in the Manufacturing Sector
Certain types of leases may be harder to transition to ASC 842. One “oddity” that affects the manufacturing sector are build-to-spec or build-to-suit arrangements.
In a typical build-to-spec or build-to-suit arrangement, a real property developer builds out real property according to a tenant’s specifications. Manufacturers may find they have build-to-spec or build-to-suit arrangements with their manufacturing plants or even, potentially, with their specialized equipment resulting in the manufacturer being, for accounting purposes, the owner of the asset during the construction period.
ASC Topic 842 makes significant changes to the build-to-suit rules. A lessee will now recognize the entire project on its balance sheet during the construction of the equipment or plant only if the lessee “controls” the asset during construction. After the equipment or plant has been completed, the arrangement is evaluated under the sale and leaseback guidance. If the lessee manufacturer does not “control” the space or asset during its construction, any amounts paid by the lessee manufacturer during construction will be treated as prepaid lease payments.
Another leasing “oddity” affecting manufacturers are embedded leases. Manufacturers should pay attention to their transportation and logistics arrangements including freight management services, and warehouse space, as these are often ripe for embedded leases. Your organization’s information technology may also have embedded leases related to its servers, data center spaces, modems, routers, and network equipment.
For More Information
The new lease accounting standard brought about significant changes for private companies and the manufacturing industry. Adoption challenges can be overcome with careful planning and execution, but it will be necessary for manufacturers to learn all they can about ASC 842 and how it will affect their business to make the necessary changes.
For assistance with the lease accounting adoption, please contact a member of our complex accounting team.
Published on January 31, 2022