New Lease Accounting: What Manufacturers Need to Know

by Eric Schmid

Alert Update: On July 17, 2019, the Financial Accounting Standards Board (FASB) voted to have an Accounting Standards Update (ASU) drafted that would, if ultimately approved, defer the non-public effective date of ASC 842, Leases by one year. The purpose of this delay is to provide constitutes sufficient time to implement a number of updated and rather complex standards that are becoming effective in consecutive years, including revenue recognition (ASC 606) and Current Expected Credit Loss (CECL) (ASC 326). We believe it’s likely that proposed deferral will be approved. However, we strongly encourage financial statement preparers to use this extra time to go through the process systemically without the pressure of a fast-approaching deadline. If companies postpone preparing for the new lease standard until 2020, they’ll face the same time crunch this time next year. An exposure draft will be made available to the public with a 30-day comment period. The FASB’s next board meeting is August 21, 2019, at which point we expect an update on this proposed ASU, or possibly ratification.

Manufacturing and distribution entities of all sizes routinely use lease arrangements as an important source of financing to expand and build upon operations. The legacy lease standard (ASC 840) became effective in 1977, and the accounting rules surrounding the two types of lease classification (“operating lease” and “capital lease”) have become very familiar to financial statement preparers and users. However, there was rising criticism and concern from certain financial statement users that the existing rules were potentially misleading to the user, particularly around the topic of off-balance sheet accounting and the lack of disclosure for leasing transactions.

During 2016, the FASB issued ASU 2016-02, Leases (the new lease standard), culminating a decade-long project. The new standard creates ASC 842, Leases in the FASB Accounting Standards Codification and will supersede ASC 840, Leases.

Major Difference In the New Lease Standard

The major difference between the existing guidance on accounting for leases and the new standard is that operating leases with a term of more than one year are now required to be reflected on the lessee’s balance sheet as a lease liability, with a corresponding “right-of-use” asset. Current GAAP requires only capital leases to be recognized on the balance sheet. This change will significantly impact many companies and will affect various financial statement ratios. It may also alter covenant calculations.

The new standard introduces many new considerations. In the remainder of this article we will focus on two of those, Embedded Leases and Impairment of the Right-of-Use asset:

Embedded Leases

Legacy GAAP contains guidance for the identification of arrangements that should be deemed leases, even though the arrangement may not contain the term “lease.” Such an arrangement may be included in a larger contract for the provision of other services and/or goods. This type of arrangement is commonly referred to as an “embedded lease.” Among other examples, contract manufacturing and logistics/warehousing arrangements may include an embedded lease.

Although addressed by ASC 840, many financial statement preparers have struggled with the embedded lease concept; consequently, many have assigned limited importance to embedded leases based on the presumption that any embedded lease would very likely be assigned operating lease classification. ASC 842’s requirement that operating leases with a term greater than one year be accounted for on-balance sheet will change the calculus.

When identifying potential embedded leases, it is important to consider:

  • Definition of a lease. Under the new standard, a lease is defined as a contract, or part of a contract, that conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration. Control over the use of the identified asset is given if the customer has both 1) the right to obtain substantially all of the economic benefits from the use of the asset and 2) the right to direct the use of the asset.The GAAP determination of whether a lease exists is based on whether the substance of the arrangement meets the definition of a lease—not whether the arrangement contains or uses the term “lease” or any equivalent term. Some preparers may incorrectly limit application of the new lease standard only to contracts that are titled as leases or rental agreements, or based on another non-GAAP determination of a lease (such as a statute). Companies will need to develop a process to review contracts to determine whether an embedded lease is present.
  • Identified asset criterion. The new lease standard indicates that an asset is typically identified by being explicitly specified in a contract. However, in addition to explicitly specified assets, there could be implicitly specified assets (machinery or production lines, for example) that are not mentioned in the contract. Identifying an implicitly specified asset could be challenging, as it will require specific knowledge of a supplier’s operations. Whenever an arrangement contains these identified assets, the lessee will need to determine if the supplier has the right to substitute similar assets during the term of the arrangement and whether or not these rights are substantive, as described in the new standard.The new standard notes that a capacity portion of an asset is an identified asset if it is physically distinct (e.g., a floor of a building or a segment of a pipeline that connects a single customer to the larger pipeline). A capacity or other portion of an asset that is not physically distinct (e.g., a capacity portion of a fiber optic cable) is not considered an identified asset, unless it represents substantially all of the capacity of the asset and, thereby, provides the customer with the right to obtain substantially all of the economic benefits from use of the asset.
  • Right to control criterion. The new lease standard indicates that to control the use of an identified asset, a customer is must have the right to obtain substantially all of the economic benefits from use of the asset throughout the period of use (e.g., by having exclusive use of the asset throughout that period). A customer can obtain economic benefits from use of an asset directly or indirectly in many ways, such as by using, holding, or subleasing the asset. The economic benefits from use of an asset include its primary output and by-products (including potential cash flows derived from these items) and other economic benefits from using the asset that could be realized from a commercial transaction with a third party.For example, assume that a manufacturer has an arrangement with a supplier to produce a specific type of widget. The supplier has a dedicated production line to produce these widgets, and due to the specificity and/or contractual arrangement, the supplier does not use this production line for other customers and is unable to produce these widgets on other lines. This arrangement could contain a lease under the new standard, as the arrangement includes tangible assets and the manufacturer effectively controls the right of use of the production line.

Impairment of a Right-of-Use Asset

Prior to ASC 842, GAAP contained very limited guidance regarding the possible underutilization or impairment of a leased asset. For example, a lessee may, as a result of business contraction, only have productively used a small portion of leased building space. With the exception of guidance applicable to a company’s termination of a lease or its ceasing use of a leased asset, companies have been, under legacy GAAP, generally prohibited from recording liabilities associated with operating leases. This will change with ASC 842, and the lessee’s acquired rights to the leased asset must be recognized as a “right-of-use” asset. This asset will be subject to existing guidance for the impairment of long-lived assets.

As noted above, current GAAP would generally prohibit liability and expense recognition even if a company’s use of a leased asset did not generate sufficient cash flows to cover the lease payments. Under ASC 842, such a fact pattern would potentially result in the company impairing the right-of-use asset and recognizing the related earnings impact.

We can help

Eric Schmid is located in the Greenville, South Carolina office of Elliott Davis and serves as the firm’s Manufacturing and Distribution Specialty Group Leader. If you need assistance or have any questions, please contact him at eric.schmid@elliottdavis.com.