Special Lease Accounting Considerations for Manufacturers and Distributors
After several years of delay and extended implementation dates, the new lease standard (FASB ASC Topic 842) is finally effective in 2022 for most private companies. Although all industries will likely be impacted by the new lease standard, there are some special considerations for manufacturers and distributors. Many manufacturers have significant factory space and equipment, which may be leased or outsourced. Distributors, especially those with multiple retail locations, will likely have significant real estate lease portfolios to evaluate. In addition to the sheer volume of lease agreements, FASB ASC Topic 842 contains several new requirements that are specific to manufacturers and distributors.
What are the Changes Under the Lease Accounting Standard?
A lease is 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. Leases will now be classified as either operating leases or finance leases (formerly capital leases). Previously, operating lease payments were expensed as rent through the income statement. All leases, other than those that are considered short-term, must now be recorded as assets and liabilities on a company’s balance sheet. A right-of-use (ROU) asset and a lease liability will be recorded based on the present value of the future lease payments. For those companies with financial statement footnote disclosures, one can flip to the operating lease commitment footnote to find the future minimum lease payments total as disclosed. Although not a direct translation, this is a good, high-level indicator of the asset and corresponding liability that will be recorded to the balance sheet for operating leases previously not capitalized.
The following are a few of the areas that are impacted by the new lease accounting standard that leadership at manufacturing and distribution companies should keep in mind.
- Embedded Leases: The new lease standard includes the concept of an “embedded lease”. Within service or supply contracts there may be specifically identifiable assets that are dedicated to the lessee for a set period of time. Some examples of this might include IT service contracts with dedicated routers or other network equipment, transportation and logistics service agreements, and shared distribution, fulfillment, or manufacturing facilities. A leasing arrangement may be determined to be present for these third-party warehouses that dedicate specific shelves to the lessee. Although not a new requirement under U.S. GAAP, inclusion of these components is more impactful given the balance sheet treatment.
- Balance Sheet Changes: The changes to the balance sheet and income statement may significantly alter financial ratios and may change the results of financial covenants – including those typically associated with asset-based lending. ROUs will be classified as long-term assets, with the corresponding lease liability being separated into current and long-term liabilities. With an increase to long-term assets and an increase to both current and long-term liabilities, the current ratio and net working capital may be negatively affected. Further, an increase to debt will increase leverage ratios. Earnings before interest, taxes, depreciation, and amortization (EBITDA) and debt service will also be adversely impacted, although the impact is dependent on the classification of the lease between an operating or finance lease. Operating leases will continue to run through the income statement as rent expenses evenly over the life of the lease. Finance leases, however, will be recognized as a combination of interest expense and amortization expense. This allows for addbacks in the calculation of EBITDA for finance leases only. However, from an income statement perspective, finance leases may cause earlier recognition of expenses than operating leases, as well as differing cash flow categorization.
Next Steps for the Lease Accounting Standard Implementation
Early evaluation of these financial covenant impacts and ongoing communication to lenders of potential covenant violations will prevent year-end reporting delays and frustrations. Likely, lenders will either amend the terms and definitions or the financial covenant components or adjust the ratio requirements to compensate for the changes from lease accounting.
Some other challenges in implementing the new lease standard, beyond the classification of leases as finance or operating, include the selection of the appropriate interest rate for calculating the present value of the lease payments, determining lease versus non-lease components, evaluating renewal terms and leasing agreements with related parties, and selecting practical expedients for implementation. At Citrin Cooperman, our Manufacturing and Distribution Practice team has extensive experience with identifying and navigating these issues and the lease accounting standard implementation. Please contact Emily Richi at email@example.com or your Citrin Cooperman advisor for more information.
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