Lease accounting has affected private companies across all industries, and manufacturing is certainly no exception, with the nature of the manufacturing businesses likely requiring multiple leases ranging from facilities to equipment and even copiers. These companies with calendar year ends were required to adopt the new Accounting Standard Codification (ASC) 842 for lease accounting effective as of Jan. 1, 2022. Although the implementation of ASC 842 is primarily the responsibility of the company’s accounting department, successful implementation requires support across many departments, especially when working with a large number of leases. Many private companies have collaborated closely with their auditors to provide guidance on implementation. As the 2022 calendar year comes to a close, there are some best practices and lessons learned to keep in mind as manufacturing businesses continue in their journey of ASC 842 implementation.
Lease Accounting Best Practices
Finding all of a company’s leases is rarely straightforward and can be very time-consuming. You’ll need to evaluate the completeness of your lease population, including embedded leases. Manufacturing companies often enter into embedded leases with equipment or freight services, as well as data services, without realizing they are leases – therefore, we recommend private companies compile an inventory of leases. Make sure you can answer the following questions about your current and active leases:
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- Approximately how many leases does the company have?
- Are the leases considered complex?
- E.g., embedded leases, renewal options, related party, complex financing arrangements, not fixed in terms of considerations, etc.
- Where are copies of the current lease agreements stored?
- Who in the company is currently involved in executing leases?
- Who in the company is currently involved in lease accounting?
- How will the ASC 842 accounting change impact financial performance metrics and financing covenants
Make appropriate transition elections and policy choices. Communication of such choices should occur between management and their auditor. Auditors typically require additional time to review the initial implementation of a new standard, as well as the subsequent accounting treatment by performing testing procedures to gain comfort over the calculated balances. You should also understand the advantages and disadvantages to each policy election. For example, the policy election to not adopt the lease standard for short-term leases could be advantageous because it could save time for short-term leases, yet could also create disadvantages by having different policies for short-term leases and long-term leases. While certain policy elections could save time, they may result in the larger right-of-use (ROU) asset or lease liability balances, which could affect covenants. Understanding these on the front end of the election is beneficial to ensure the company is making the right decision.
Understand how your leases impact the calculation of a ROU asset and lease liability. This includes comprehension of lease terms, dates, payment details, non-lease components and discount or incremental borrowing rates.
Research appropriate discount rates. The discount rate used by the lessee should be the rate implicit in the lease whenever that rate is readily determinable. If the rate implicit in the lease is not readily determinable, a lessee uses its incremental borrowing rate. Management of private entities can elect the appropriate risk-free rate practical expedient by class of underlying asset of all leases for which they are the lessee. The lessee should still use the rate implicit in the lease when it is readily determinable, even if it has elected the risk-free rate discount rate expedient.
Finance vs. Operating Lease
You must be able to determine the difference between finance and operating leases. Operating leases historically function like renting, whereby the asset was excluded from the balance sheet. Capital leases (now called financing leases) function like a loan, and the asset and related debt was recorded on the balance sheet. Make sure your lease agreement clarifies this information and takes into account different categories of items, such as:
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- Vehicles (tractors, vans, cars, delivery services)
- Storage (warehouses and supply storage)
- Office equipment (computer, printers, copies, scanners)
Decide if your lease accounting will be handled in-house or outsourced. When outsourcing, choose a software solution to upload and handle all ROU asset and lease liability calculations. Rather than perform manual calculations, you’ll be able to perform all calculations and disclosures within the software system, which will save the management team valuable time. In addition, the use of a software system for implementation may result in a better audit trail, which could reduce fees charged by the auditor when they perform the audit. However, remember that new internal controls will need to be implemented to identify and evaluate new and modified contracts to determine whether they contain a lease. Also, remember that these entries should be calculated monthly, so using a software solution will not only save time at implementation but also at each month-end close.
Assess the impact of previous balances that might affect transition balances, including: prepaid/deferred rent balances; incentives/tenant improvement allowances; initial direct costs; and favorable/unfavorable intangible assets. Reconciling these amounts to what is recorded in the general ledger is important to ensure that legacy balances (e.g., deferred rent) have been appropriately cleared, and the ROU asset and lease liability are appropriately stated.
Understand how the implementation of ASC 842 impacts company performance metrics, reporting and compliance to help you manage important benchmarks and key performance indicators.
Lastly, discuss the implementation with governance and stakeholders so that they understand the new ROU asset and lease liability, as well as the presentation and disclosure.
For more information regarding lease accounting implementation for your company, talk to your Windham Brannon advisor. You may also contact Daniel Pullman or Jeff Yelkovich.
