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After several postponements, the update to the accounting standard for leases Accounting Standards Update (ASU) 2016-02, Leases(Topic 842) is in effect for private companies. Late last year, the Financial Accounting Standards Board (FASB) voted unanimously against further delay. This means that companies that follow US generally accepted accounting principles (GAAP) must adopt the new standard for fiscal years beginning after December 15, 2021 (calendar year 2022).
Related Reading: Topic 842 Tenant Basics
In a nutshell, the updated standard requires companies to report both operating leases and finance leases on their balance sheets (with the exception of short-term leases with a term of 12 months or less). Previously, operating leases did not have to be recorded on the balance sheet. Under the updated standard, a lessee under an operating lease must recognize a “right-of-use” asset and a corresponding liability for lease payments over the expected term. Generally, assets and liabilities are based on the present value of the minimum payments expected to be made under the lease, with certain adjustments.
It is not uncommon for manufacturers to have a significant number of operating leases for buildings, equipment, vehicles, technology and other assets. As a result, the updated standard, once adopted, will immediately increase your company’s assets and liabilities, making it appear more leveraged than before. This can lead to technical violations of loan covenants that limit your leverage or require you to maintain certain debt-to-equity ratios, so it is important to discuss the impact of the standard with lenders and, if necessary, negotiate amended loan covenants.
For many manufacturers, the biggest and most time-consuming challenge will be locating all of your leases and extracting the data needed to comply with updated guidelines. Leases are generally not standardized, so reviewing them and collecting the required data can be a manual, labor-intensive task. You’ll need to enter and analyze dozens of data elements, including lease terms, payment schedules, end-of-contract options, and incentives. To complicate matters further, some of the data you will need may not be in the lease itself, so additional legwork may be required.
Another challenge will be identifying lease agreements that must be accounted for under the updated standard but are not found in traditional lease agreements. If an agreement gives you the right to control an identified asset for a period of time in exchange for payment, then it will be considered a lease under the updated standard.
These “embedded” leases can be in service, supply, transportation, or information technology agreements, as well as some toll manufacturing agreements. For example, if a contract of carriage gives you exclusive rights and control over a specific vehicle or fleet of vehicles, you may need to treat it as an integrated lease and separate the lease and non-lease components. of the contract for reporting purposes.
Locating leases (including integrated leases), collecting data, and analyzing that data for lease accounting purposes is a lot of work. To ease the burden, lease-intensive businesses should consider using lease accounting software to automate the process of managing and tracking their leases and calculating their lease assets and liabilities. Contact your ORBA CPA to find out more.
The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.
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