Changes to Manufacturing Lease Accounting

Most manufacturers, wholesalers, and distributors lease operating facilities or equipment, whether from a third party or a related party. That means nearly all of these businesses will be impacted by the Financial Accounting Standards Board’s (FASB) update to the accounting standards for leases under generally accepted accounting principles in the United States (GAAP). The updated standards, which will take effect for private companies for fiscal years beginning after Dec. 15, 2020, will affect both lessors and lessees.

What will change with your financial statements beginning Jan. 1, 2021? The FASB wishes to redefine a lease contract, report it in your balance sheet (whether or not it was previously there), and expand disclosure on your obligations in the footnotes to the financial statements.

Impact on Lessees

If your business enters into any lease of property, plant, or equipment – large or small – your financial statements will likely change. Currently, GAAP requires lessees to classify leases as either capital leases or operating leases based on a series of economic tests. Lessees currently recognize assets and liabilities for capital leases only, while leases classified as operating leases remain off-balance sheet, with no recognition as an asset or liability.

The updated standards will require a lessee to classify leases as either finance leases (similar to capital leases under the current standards) or operating leases. All leases, except for those considered short-term leases under the guidance (12 months or less), will have to be recorded on the balance sheet with a right-of-use (ROU) asset and a lease liability.

An example of implications: A manufacturing company leasing a building currently classified as an operating lease for three years from a third party for $23,875 per month currently has no asset or liability recorded on the balance sheet under current GAAP. Under the new lease accounting standards, that same lease is now required to be recorded as an $800,000 ROU asset and lease liability on the balance sheet (36 payments of $23,875 discounted at 5%). Adding $800,000 to both assets and liabilities can significantly change the complexion of the balance sheet.

Leases with Related Parties

As this new guidance was being discussed, many closely held businesses leasing their facilities from commonly owned entities contemplated amending the lease agreements to operate on a month-to-month basis (thereby falling into the “short-term lease” exception). The FASB made provisions requiring that any related-party leasing arrangements be considered long-term if the relationship is reasonably certain to continue in a long-term manner. As a result, any leases with related parties should be formalized so the corresponding ROU asset and lease liability are determinable, unless the relationship is truly short-term in nature.

Implementation

What has surprised many CPAs and financial statement preparers alike is the cost and time associated with implementation. Questions and considerations range from:

• How to determine if a lease under the old standards is still a lease under the new guidance
• How to calculate the ROU asset and lease liability and future lease modifications
• What the impact is on income statements and cash flow statements
• What recognition looks like in year one
• How banks will react to new-look balance sheets and if this impacts financial covenants

The implementation of this new accounting change will be difficult for many. Considering the potentially significant changes to financial statements as it relates to leases, it is important for manufacturers, wholesalers, and distributors to begin assessing current lease contracts and future obligations now.