At Sikich, we have a large number of clients that operate in the Capital Goods sector – including OEM (and allied) manufacturers, distributors as well as service organizations. This focus has given us the opportunity to build up a comprehensive suite of high-value solutions and services that help address the most pressing needs of this dynamic sector, including:
- Improved supply chain resilience
- Increased data visibility and analytics
- Organizational workflow automation
- Industry 4.0 / Factory of the Future readiness
As much as we enjoy working with our clients developing strategies for digital transformation, we actually spend a lot more time working with them on the nuts and bolts detail of strategy execution. So in that vein, deep in the details, one of the topics we’ve been talking a bit about recently is the day-to-day impact on our clients of the change in accounting standards around equipment leasing. We work with business applications that will support the new standards, but I was more interested in the other impacts this change might have on selling capital goods.
Thankfully I could rely on Sylesh Babu, CPA and Sikich Partner, to answer all the questions I had.
Changing lease standards for OEMs (ASC 842)
There is a new lease standard that non-publicly traded companies will be required to meet in those non-public entities’ financial reporting. This will go into effect on January 1, 2022, with the expectation that they have their accounts reflected by the year-end 2022 with these new standards. ASC 842 is the formal name for this new standard.
For the OEMs that we work with, we wondered about whether or not ASC 842 is going to impact their business model. In particular, when the equipment is sold via a lease, is the change in standard going to change conversations with customers? Are customers going to want to talk about some other transaction mechanism that keeps it off their balance sheet? And what about when the equipment sale is modeled around equipment-as-a-service? Are you able to stand up an equipment-as-a-service business where it is entirely different from the typical financial arrangements of a lease and rental?
We thought it might be of some value to help our OEM clients understand the impacts of the new standard for their customers and offer some talking points from our conversations. Such as “I’m aware that you’re leasing this equipment from us right now; did you know that you’re going to have to make changes to that?”
What behavior changes do you think our OEM and equipment maker customers might see in their sales cycles? What impact is it going to have, because they’re going to need to explain to their customers, potentially, how it’s different.
There may be very little the lessees could do to avoid carrying the lease assets in their balance sheet. Other than the operating leases, which are less than 12 months. Generally, the International Financial Reporting Standard (IFRS) has a substance over form concept, but surprisingly, they said substance over form is not relevant for the lease standard. What is legally enforceable is what is relevant.
How you account for the lease standard is determined by what is legally enforceable. For the most part, the lessees will need to have the asset as a right-to-use asset in the balance sheet with a corresponding lease liability.
One of the first things the customers of our OEM clients will need to ensure is that they have the software applications to manage their lease portfolio. This has to be done now, before January 1, 2022, so everything is put in place.
The biggest task for OEM’s customers, the lessees, will be “completeness.” Surprisingly, many companies don’t even know that the financial arrangement for an asset purchase has been a lease. If the documents they’ve received are not titled “LEASE,” they may easily mistake the transaction for not being a lease! Service contracts, for example, might include embedded leases, like a right-to-use asset. So identifying those could be a challenge.
WHAT IF ONE OF OUR OEM CLIENTS HAS A CUSTOMER THAT HAS BEEN LEASING A PIECE OF EQUIPMENT OFF THE OEM FOR 15 YEARS AND THEY STILL HAVE FIVE YEARS TO GO. DO THEY NEED TO MOVE THAT INTO THEIR FIXED ASSETS WITH THE BALANCE OF MONEY OWING ON THAT LEASE?
They don’t have to reassess the lease classifications if they implemented ASC 840 appropriately. They have a practical expedient option for initial implementation. So, for any existing lease, they could continue the way they’re accounting for it, except that both operating lease and finance lease would carry a right-to-use asset in the balance sheet and a related liability. They don’t have to re-measure, because now with the new lease standard, some upfront cost needs to be capitalized. However, as noted above, a right-of-use asset will be recognized for all leases, both finance and operating leases, upon adoption of ASC 842.
So what happens if the equipment maker instead decides to do equipment-as-a-service? Will that capture under the lease standard? That’s entirely a different sort of financial arrangement.
It is, but one of the criteria is “controls the use of the asset.” Who is controlling the use of that asset? Generally, they would have to carry the asset in their balance sheet. There’s no way around it because you have to carry a right-of-use asset in the balance sheet, even if it’s an operating lease.
So what would be the criteria, let’s say a café was allowed to take an equipment-as-a-service coffee machine and use it, and only pay $0.03 a cup, but they were able to, at any time, swap that machine out, get another one.
So it also depends on who has the rights and if they are replacing it with a machine similar to the older one?
You must ask if it has any significant net cash flow impact on the lessor. Here’s an example. Let’s say we are having an event. In this case, it will be our busy season. From January through April, we will make an industrial-strength coffee machine available for our employees. We will lease it for three or four months. In this case, it would be an operating lease because, after April, we are giving it back, then next year again, we may have to lease for another three or four months. In this example, let’s say we have the option to renew it or keep it, and if it’s very likely we’ll exercise this option, then it would become more of a finance lease.
Why do companies want to keep it off their balance sheet?
One reason could be to enjoy the benefits of an asset and avoid the risk of ownership. Another reason could be the potential negative impact on their working capital ratios (any lease payments due within the next twelve months would be a current liability with no corresponding current assets). It could also stem from a P&L standpoint.
There is a potential for an impairment of the right of use asset, with a related charge to P&L. Previously, since there were no right of use asset in the balance sheet for an operating lease, there would be no such impairment charge to the P&L. Also, for finance leases, the asset will be amortized as an expense in the P&L over the estimated lease term on a straight-line basis. The sum of the interest and amortization creates a front-loaded lease expense pattern.
So, from an ownership perspective, in the circumstance of a lease, the ownership does not transfer from the OEM. So they’re going to have to think of another way to communicate with customers about why it’s okay to go on the balance sheet, after many, many years of saying, “Hey, yeah, you keep it off your balance sheet.”
OEMs who could offer new financing options would be a good selling point. Ultimately, my advice to OEMs is to start having this conversation with their lessees. I think it’s most important to educate them. The sooner they start the conversation, the better.
Have any questions about how ASC 842 will affect OEMs? Please reach out reach out to one of our experts at any time!