The new lease accounting standard is not so new anymore, but your company still has time to perfect its lease reporting strategy. ASC 842 went into effect for most publicly traded companies in 2019, and for most private companies and nonprofits earlier this year.
As you’re reviewing and tweaking your implementation of the new standard, there are a few things you should be thinking about. But first, let’s remind ourselves of what changed.
Brief Overview of ASC 842
Organizations that (1) lease assets, and (2) follow generally accepted accounting principles (GAAP) must now report their leases under the new guidelines.
ASC 842 requires lessees (i.e., those who lease assets) to report nearly all leases on their balance sheet. Under prior guidance, only certain long-term leases were reported on the balance sheet, with most hitting only the income statement when the company made a lease payment.
Under the new standard, all long-term leases — both operating and finance leases — are reported on the balance sheet as right-of-use assets and corresponding lease liabilities for the discounted present value of the remaining lease payments. Only assets with lease terms of less than 12 months can remain off the balance sheet.
As one can imagine, entities with a high number of leased assets — like most businesses in the manufacturing and distribution space — will face a few challenges when complying with the new reporting standard. If you are in the manufacturing and distribution industry, here are a few unique scenarios you should be thinking about.
It isn’t always easy to identify when you have a lease. Often, leases are embedded into other contracts. Consider the following example:
A manufacturing entity contracts with a distribution center to prep and ship one of their products. Packaging the product requires specialized equipment, which the distribution center builds and uses exclusively for the manufacturer. In this scenario, the contract between the manufacturer and the distributor likely has a lease component. When accounting for this contract, the manufacturer should identify how much of the contract price represents their right to use the packaging equipment and record that amount as a lease on their balance sheet.
As you’re looking through your contracts, here are a few questions you can ask yourself to help you spot an embedded lease:
- Does the contract require an asset to be built or customized for you?
- Can you dictate how or when the asset is used?
- Are you the only customer to use the asset?
- When your contract ends, will the other party retire the equipment?
- Is a specific asset listed in the contract?
If you answered yes to any of these questions, you likely have an embedded lease.
The Financial Accounting Standards Board (FASB) wants shareholders to see, on the face of the financial statements, your obligation to make future lease payments. When calculating your future lease liability, you must discount your future lease payments so they are presented in today’s dollars.
Most standard lease agreements state an interest (or discount) rate, but embedded leases and less formalized lease agreements won’t. You may be able to determine an implicit rate if you know (1) the present value of your future lease payments, and (2) the present value of the amount your lessor expects to derive from the underlying asset when your lease expires — we often call this the asset’s “residual value.” Unfortunately, most lessees aren’t privy to the lessor’s residual asset value, so in practice, most lessees use their incremental borrowing rate or their risk-free rate as their discount rate.
Incremental Borrowing Rate
Your incremental borrowing rate is the interest rate you’d pay to borrow funds to finance a similar asset with similar payment terms in a similar economic environment. Public companies are required to use their incremental borrowing rate, but private entities also have the option to use their risk-free rate.
Your risk-free rate is determined using the current Treasury bill rate and your credit rating. Daily T-bill rates can be found on the Treasury’s website.
Determining the right discount rate is important because you’ll use the same discount rate for the entirety of your lease term. Even a slight rate change could have a noticeable impact on your balance sheet. Take the time to select the right discount rate, and feel free to run your calculations by a trusted advisor if you’re unsure.
Do you plan to renew your lease at the end of the lease term? The answer to this question is more important than you might think.
Under ASC 842, short-term leases may be reclassified as operating leases if you plan to renew your lease each year. The FASB wants users of the financial statements to know when you are leasing assets over a multi-year period, even if the lease agreements themselves are for only 12 months at a time.
If your renewal assumptions change, you may have to recalculate your lease liability and your right-of-use asset. Consider the following example:
A distributor enters into a two-year agreement with a customer that requires them to temporarily lease new storage space. Their storage facility had an initial lease term of two years, with an option to extend the lease an additional three. At the time they signed the contract, they didn’t think they would renew the lease.
After the first year, the customer was so pleased with the distributor’s work that they decided to extend their contract with the distributor indefinitely. At this time, the distributor knew they would be renewing their lease for the storage facility at the end of its two-year term. Because their assumptions changed, the distributor would need to remeasure their lease and adjust their right-of-use asset and corresponding liability to reflect those new assumptions.
The lease accounting standard is something you’ll need to be thinking about throughout the year even after you’ve already implemented your compliance strategy. There may be things you need to adjust or disclosures you need to edit to get the reports just right. Contact your MarksNelson advisor if you have questions.