The New Lease Accounting Rules Are Here, Are You Ready?

Operating leases will move onto the balance sheet with the new lease accounting rules implementation. At the beginning of this year, public companies started using Accounting Standards Update No. 2016-02, Leases. Private companies must apply the updated guidance for fiscal years beginning after December 15, 2020 (2021 for calendar-year companies), and for interim periods within fiscal years beginning after December 15, 2021.

Private companies’ deadlines include a one-year deferral. The Financial Accounting Standards Board (FASB) unanimously agreed this summer that a delay in implementation deadlines would benefit private companies. Because many businesses were struggling with resource constraints and insufficient technology expertise while setting up internal systems after having to adopt revenue rules, they informed the FASB that they were not ready to implement the lease standard.

Implementing the updated lease standard can be expensive and time-consuming, based on feedback from public companies. So, even with a one-year reprieve, private manufacturing companies should start the implementation process as soon as possible.

What You Should Know About Lease Accounting

Under current U.S. generally accepted accounting principles (GAAP), private companies classify leases in two ways:

1. Capital (or finance) leases. Underlying asset ownership is transferred to the lessee at the end of the term in these financing arrangements. They are reported on the lessee’s balance sheet.
2. Operating leases. These off-balance-sheet arrangements provide use rights for the underlying asset during the lease term. They must be disclosed in the financial statement footnotes.

Leases with a minimum one-year term are required to be reported on the balance sheet by the updated guidance. The lessee records a “right of use” asset — generally equal to the minimum payments under the lease, discounted to present value — as well as a liability reflecting its payments obligation. The distinction between operating leases and capital leases is maintained under the new rules, which affects lease-related costs expensing.

If a contract conveys the right to control identified asset use for a period of time, it contains a lease. The term “control” refers to the right to direct the asset use and to obtain substantially all resulting economic benefits.

Identifying “embedded” leases in other contract types, including certain service contracts and contract manufacturing arrangements, is a major challenge under the updated rules. For example, a transportation contract may provide exclusive rights to, and control over a specific vehicle or vehicle fleet. Companies will need to separate lease and nonlease contracts components and provide detailed disclosures under the updated guidance.

What This Means for Manufacturers

Do you have significant operating leases for facilities, warehouses, equipment, vehicles and other assets? If so, evaluate new lease accounting rules’ impact. You’ll see an immediate increase in assets and liabilities on your balance sheet when they take effect. This can make your company appear more leveraged than before, affecting the way investors and lenders view your financials.

Moving leases to your balance sheet may cause technical violations of loan covenants that limit your debt or require you to maintain certain debt ratios. Discussing the new accounting rules with your lenders is important to minimize surprises when you deliver your financial statements and, if appropriate, to negotiate amended loan covenants.

What’s Next?

Review your contracts to determine which ones are leases or contain leases before the new lease accounting rules take effect. Then evaluate your accounting systems, processes and internal controls to ensure that you’re prepared to track and record the necessary data for both reporting and disclosure purposes.

The types of information you’ll need to gather, and the calculations needed to determine lease values and expenses will expand with the new rules. To simplify matters, you may want to explore lease management software that automates the process.

Steps to Boost Your Business Credit Score

Rather manage the hassle of new accounting rules for leases compliance, you may decide to buy assets outright going forward. Before you finance a major asset purchase, however, it’s important to check your business’s credit score and take steps to improve it. Here are some ways to boost your credit score.

• Pay bills on time. Credit bureaus will examine a business’s history of paying bills on time. Some require you to pay bills up to 30 days ahead of schedule to achieve the maximum score.
• Use credit ― but not too much. Responsible credit utilization will help your credit score. But a use ratio of 30% or higher could raise a red flag.
• Get credit for trade credit. The credit bureaus usually rank trade credit highly, but suppliers and vendors aren’t required to report it. If your relationships with suppliers and vendors are strong, encourage them to provide trade references to the credit bureaus.
• Watch your personal finances. An owner’s personal credit score can influence the business credit score.

Manufacturers with low business credit scores may not qualify for bank loans. If they don’t have cash on hand to fund a purchase, leasing — and complying with the new lease accounting rules — may be the only viable option to acquire fixed assets.

Need help?

Significant time and effort is expected for most private manufacturers to comply with the new lease accounting rules. Contact Weaver today for assistance and implementation guidance.

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