Leasing is an important source of financing used by manufacturing companies to acquire critical pieces of equipment or facility expansions, while avoiding a large initial cash investment. Whether a manufacturer has only one lease or many, the new accounting standard for leases, ASU 2016-02, Leases (Topic 842), may have a significant impact on financial statements prepared in accordance with Generally Accepted Accounting Principles (GAAP).
Defining Aspects of the New Standard
The new standard is effective for non-public companies with fiscal years beginning after December 15, 2019 with early adoption permitted. The standard allows for two different optional transition methods. Under the modified retrospective method, an entity initially applies the new lease standard as of the beginning of the earliest period presented in the financial statements. This means that for the calendar year non-public businesses presenting two comparative years, lessees must retroactively recognize lease assets and liabilities for all leases starting on January 1, 2019—even though those leases may have expired before the effective date. Lessees also must provide the new and enhanced disclosures for each period presented, including the comparative periods.
Under a second optional transition method, an entity initially applies the new lease standard at the adoption date and recognizes a cumulative effect adjustment to the opening balance of retained earnings in the period of adoption. Consequently, an entity’s reporting for the comparative periods presented in the financial statements in which it adopts the new lease standard will continue to be in accordance with current GAAP (Topic 840, Leases). An entity that elects this transition method must provide the required Topic 840 disclosures for all periods that continue to be in accordance with Topic 840. The amendments do not change the existing disclosure requirements in Topic 840.
Changes in the New Rules
Under existing rules, a lease is categorized as either an operating or capital lease.
Capital leases are recorded on the balance sheet as both a fixed asset and a liability.
Operating leases are considered off-balance sheet with monthly rent being recorded to expense as its being paid.
Under the new leasing standard, the term “capital lease” is replaced by “finance lease,” but is defined by classification criteria similar to the current standard (Topic 840, Leases). The more significant change of the new standard is the requirement that operating leases over 12 months in duration be recorded on the balance sheet as a right-to-use asset and a corresponding liability for the obligation to pay rent. This is a profound change: all those off-balance sheet operating leases will now need to be measured and recorded on the balance sheet. This will have a direct impact on financial statement ratios used by lenders and other financial statement users when evaluating financial position and performance.
Therefore, this new accounting standard change will have a direct impression on existing debt covenant arrangements and book/tax difference computations, which could affect certain state and local tax apportionment calculations and transfer pricing.
Accounting Policy Election
For leases with a term of 12 months or less, an accounting policy election can be made to record only the monthly rent to expense as it’s being paid. However, for leases with related parties and month-to-month leases, it is important to determine if the arrangement is truly month-to-month.
Indicators of a longer-term lease can include:
- The existence of a lease renewal option that is reasonably certain to be exercised by the lessee.
- Significant leasehold improvements being depreciated over a period longer than one year.
- Lessee is the sole user of the leased assets and provides necessary cash flow to the lessor to service the debt.
- It would be economically disruptive and commercially unrealistic for the lessee to relocate to a new facility in the short-term.
If these criteria are met, month-to-month leases may need to be reported under the new guidance as right-to-use assets, and the related liability measured and recorded, as the lease truly extends beyond a 12-month period.
Lease Classification Requirements
It’s also important to note that the new lease standard doesn’t eliminate the need to classify leases as either a finance lease (capital lease) or operating lease, and the lease classification requirements to determine which class of lease the contract falls under remained relatively unchanged. If the lease is determined to meet the requirements of a finance lease, then it’s accounted for under the new lease standard as it was under the old accounting standard. If it meets the requirement to be classified as an operating lease, it will result in different recognition of expense over the lease term, with interest expense and depreciation of the asset. Lease classification should be evaluated at the beginning of the lease and only reassessed when the contract is modified or if there is a change in the evaluation of whether a purchase option will be exercised.
Recording Lease Costs
The new standard will also change how certain lease costs are recorded. Under current GAAP rules, all executory costs, such as those for property taxes or insurance, are excluded from minimum lease payments. However, under the new standard, these types of costs, if payment is fixed to the lessor, are included in the lease payments used to calculate the lease liability and right-to-use asset. Additionally, initial direct costs are deferred and recognized in the right-of-use asset value.
As companies may have numerous leases that exist in various locations throughout their organizations, it may be time-consuming to locate and extract all the data from these leases. Start planning now by locating and extracting the data for your organization’s leases to be in compliance with this new standard.
If you have questions about lease standards or changes to classification rules, please contact us.
About the Author
Jeremy Michael, CPA
Senior Manager, Certified Public Accountants & Advisors