Impact of Lease Accounting Standard on Manufacturing, Distribution and Retail Companies

In February of 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2016-02. This ASU, along with several subsequently issued yet related ASUs, is codified in Accounting Standards Codification (ASC) Topic 842, Leases, amending the accounting guidance for leases. On Nov. 15, 2019, the FASB announced a delay in the effective date of the ASU for non-public business entities, who are now required to apply ASU 2016-02 for reporting period beginning after Dec. 15, 2020.

Under ASC 842, a company is required to recognize most leases with terms greater than 12 months on its balance sheet. Specifically, lessees are required to recognize at lease commencement, both:

  • A right-of-use (ROU) asset: representing the lessee’s right to use the underlying asset over the term of the lease.
  • A lease liability: representing the lessee’s contractual obligation to make lease payments over the term of the lease.

This presentation under ASC 842 represents a change for arrangements previously treated as operating leases, which were historically considered “off balance sheet” obligations.

The FASB believes balance sheet presentation of leases will provide a clearer view of a company’s future commitments by ensuring that rights and obligations associated with operating leases are reflected on the balance sheet instead of relegated to the financial statement footnotes.

Under ASC 842, leases recorded on the balance sheets will be classified as either finance leases or operating leases, which will determine the presentation of the related expense in the income statement. Finance lease arrangements will result in depreciation and interest expense recorded each reporting period, while operating lease assets and liabilities will be amortized and accreted, respectively, and presented as lease expense in the income statement.

Manufacturing, distribution and retail companies, particularly those with significant operating lease activity under current lease accounting guidance, can take advantage of the delayed effective date of ASC 842 to prepare for implementation. Specific considerations prior to implementation include:

  1. Impact to Balance Sheet and Financial Ratios
  2. Lease Population Completeness Considerations
  3. Negotiation of Future Arrangements
  4. Tax Impact
  5. Assurance Perspective
  6. Future Operations, Processes and Related Controls
1. Impact to Balance Sheet and Financial Ratios

With the presentation of the ROU asset and lease liability on the balance sheet for arrangements previously presented as operating leases, manufacturing, distribution and retail companies should expect increases in balance sheet amounts (e.g., long-term assets and both current and long-term liabilities). Companies with significant existing equipment leases may be surprised by the impact on reported balance sheet amounts, since many equipment leases will be added to the balance sheet upon implementation of ASC 842. These financial statement presentation changes may impact certain financial ratios such as:

  • Leverage ratio – debt/equity
  • Current ratio – current assets/current liabilities
  • Debt to earnings before interest, taxes, depreciation, and amortization (EBITDA) – debt/EBITDA
  • Return on assets – net income/assets

Manufacturing, distribution and retail companies should assess the impact of ASC 842 implementation on any financial ratio-based covenants with financial institutions, investors or other parties in order to avoid violations. Once an assessment of the impact on relevant financial ratio-based covenants is completed, it is important to communicate with financial institutions, investors and other parties as soon as practical to modify affected covenants or to add language requiring affected covenants to be calculated under the accounting guidance in effect as of the original date of the related agreement.

For operating leases in addition to finance leases, the ROU asset will be subject to existing impairment guidance in ASC 360, Property, Plant, and Equipment. Consistent with ASC 360, the impairment test for ROU assets will often be performed at an asset-group level. The lessee may elect to include or exclude the lease liability from the asset group. The associated rent expense should also be included or excluded following the company’s election to include or exclude the liability. Under ASC 842, if an impairment loss is recognized for an ROU asset, the adjusted carrying amount of the ROU asset would be its new accounting basis.

2. Lease Population Completeness Considerations

In the transition to ASC 842, it is important to identify all leases. While many leases may seem straightforward, such as leases for real estate or equipment, others may be embedded within other service contracts. For example, a router that is obtained as part of an internet service may be considered a leased asset. By electing the package of three transition practical expedients, companies must utilize the guidance in ASC 840 to determine if the contract is or contains a lease when implementing ACS 842.

Embedded leases are commonly found in the following arrangements:

  • Dedicated/Shared Manufacturing Facilities
  • Dedicated/Shared Distribution Centers
  • Advertising Contracts
  • IT Services

Below are some examples where judgement and further analysis is required to determine the presence of a lease component.

Situation 1: Merchandise supply contracts without a minimum quantity commitment.

Facts: A company enters a contract with a manufacturer to manufacture a certain volume of goods. A purchase order (PO) is issued when the plan is put in place. The PO becomes firm when the price is locked. This can happen any time before the goods are delivered. Per the company, the factories never start the work unless the PO is issued. The arrangement is a Free on Board (FOB) shipping point, therefore, ownership transfers once shipped. In the cases where there are fully dedicated factories, the company has the ability to exercise significant influence over the facility. However, in this case, the buyer is under no obligation to purchase merchandise from the supplier on an ongoing basis.

Analysis: In this example the factory is a specified asset as it is clearly identified within the arrangement. However, the company does not operate the factory and as such does not have the ability to direct the employees or control access to the production line, as the factory is controlled by the supplier. The supplier has the right to decide the production level at which to run the factory and which customer contracts to fulfill. The supplier could decide to use the factory to fulfill other customer contracts during the period of use. The customer rights are limited to output from the factory that agree to the terms of an executed purchase order, and as such the customer has the same rights regarding use of the factory as other customers purchasing merchandise from the factory. The price is based on the volume agreed upon in the PO for that year. Hence, it is based on per unit of output.

Due to these considerations, the contract is not considered a lease.

Situation 2: Merchandise supply contracts with subsidiaries

Facts: A company enters a contract with a manufacturer to manufacture a certain volume of goods. The company is a 50 percent owner of the facility. Per further analysis performed by the company, this factory is considered a variable interest entity (VIE) for the company. Does this manufacturing agreement constitute a lease of the facility and equipment?

Analysis: The company considers the factory a VIE. The company may or may not present the VIE as a consolidated entity on their consolidated balance sheet due to materiality considerations. Regardless of how the VIE is presented on the balance sheet, it is still a VIE and hence, the underlying asset is owned by the company for accounting purposes. A company cannot lease an asset that it already owns. Therefore, there is no specified asset and lease consideration is not necessary.

Situation 3A: Shared distribution center

Facts: A retailer utilizes a distribution center to carry out disbursements of finished goods to its customers. The vendor provides the company a warehouse space along with some equipment. Neither the space nor the equipment is dedicated for use by the company. It is a shared facility and the company utilizes roughly 50 percent of the capacity. The distributor has multiple locations, and the company’s merchandise can be held at any of their locations as the orders are being fulfilled. The company does not have the ability to operate the facility or the assets or control physical access. Additionally, the vendor is currently serving other major customers.

Analysis: Based on the facts above, the facility and the equipment are not dedicated to the company and can be utilized by other customers. These assets are interchangeable in nature and hence, there is no specified asset. Therefore, this contract is not a lease.

Situation 3B: Dedicated distribution center

Facts: Assume the same facts as in scenario 3A, except the distribution facility if fully dedicated to the customer. The customer utilizes 100 percent of its capacity.

Analysis: In this case, even though there is no stated agreement that the vendor may not serve other clients, by utilizing all the capacity of the facility, the customer may exercise significant control over the facility and its operations. This may be a lease.

Situation 4: Advertising Contract

Facts: A company enters a marketing services agreement which encompasses a variety of marketing and advertising vehicles, one of which includes billboards.

Analysis: Although this contract could be written as a marketing services agreement, the right to use one or more billboards may result in a lease if the billboard is specifically identifiable and dedicated to the customer for a period.

Situation 5: IT Contract

Facts: A distributor enters into a network services and security agreement with an electronic data storage provider. The services are provided through a centralized data center and use a specified server (Server No. 9). The supplier maintains many identical servers in a single, accessible location and determines, at inception of the contract, that it is permitted to and can easily substitute another server without the customer’s consent throughout the period of use.

Analysis: Based on the facts above, the vendor can interchange the underlying asset without the customer’s consent. As the asset is interchangeable in nature and service is not dependent upon a specific asset, there is no lease.

It is important to note that there is considerable judgement involved when reviewing a contract for embedded leases. A slight alteration in facts and circumstances may result in a different conclusion. For example, if there is a specific asset that is 100 percent dedicated to the customer, the result may change.

3. Negotiation of Future Arrangements

The impact of ASC 842 may be an important factor in evaluating whether to structure the future acquisition of assets as a lease arrangement or a purchase arrangement. The consideration of future arrangements is particularly important for manufacturing, distribution and retail companies with significant equipment lease activity as many such lease arrangements may move on to the balance sheet under the ASC 842. Manufacturing, distribution and retail companies should perform an inventory of future asset needs and begin to plan for these by understanding the trade-offs between lease and purchase arrangements for each.

4. Tax Impact

ASC 842 will have a noticeable impact on financial reporting for lessees, but the effect on taxes may not be obvious. The new lease standard does not change the lease accounting for federal income tax purposes. Therefore, without a corresponding change in tax basis, deferred tax accounting may be impacted. Implementation of ASC 842 could result in new deferred tax assets, liabilities or additional book to tax differences in a company’s income tax provision. Under ASC 842, lease assets are subject to impairment, which is often reversed for tax purposes. Manufacturing, distribution and retail companies should understand and plan for the potential tax impact.

5. Assurance Perspective

Manufacturing, distribution and retail companies audited by an independent accounting firm should maintain relevant documentation of the ASC 842 implementation process, as the independent auditor may require the documentation in order to complete the audit. Such documentation should include evaluation of lease classification as finance or operating, selection and application of the transition method, discussion of any practical expedients applied and the company’s evaluation of embedded leases.

6. Future Operations, Processes and Related Controls

To comply with ASC 842, companies may need to implement changes to their current control environments and business processes. To ensure compliance, new controls may need to be put in place. Significant judgement will be required to asses lease terms from the lens of ASC 842, specifically related to lease term, allocation of lease payments to lease and non-lease components, and remeasurement events.

Conclusion

By delaying the effective date for non-public business entities, the FASB has created an opportunity for manufacturing, distribution and retail companies to fully consider the impact of ASC 842 and prepare for the upcoming transition. You can find more helpful information regarding ASC 842 by visiting DHG Knowledge Share, or contact the author below.