New Lease Standard’s Impact on Manufacturing, Distribution, and Retail
Marcy Greenfield and Bonnie Mann Falk
12.15.22 | Industry Insights
The new lease standard, which became effective late last year, has a major impact on private manufacturing, distribution, and retail companies with contracts that contain a lease. In this article, we review how to navigate the new guidance and how it may impact companies in the industry.
The New Landscape for Lessees and Lessors
ASC Topic 842 – Leases supersedes all previous guidance on accounting for leases by lessees and lessors. The new guidance is effective for private entities for fiscal years beginning after December 15, 2021 (i.e., 2022 for calendar-year entities) and interim periods within fiscal years beginning after December 15, 2022.
For lessees, all leases with terms of twelve months or more are reflected on the balance sheet as right-of-use assets with related lease liabilities and are classified as either operating or finance leases.
For lessors, all leases are classified as sales-type, direct financing, or operating leases. At the inception of a contract, an assessment is made to determine whether the contract is, or contains, a lease. A contract is a lease or contains a lease if the contract conveys to the lessee the right to control the use of an identified asset for a period of time in exchange for consideration.
Contract Considerations for Lessees
- Fixed payments, less any lease incentives (i.e., payments to or on behalf of the lessee and losses incurred by the lessor as a result of assuming a lessee’s preexisting lease with a third-party payable to the lessee).
- Nonlease components included in the lease – separate or elect the practical expedient to combine the lease components and the nonlease components
- Variable lease payments over the lease term that depend on an index or a rate (e.g., LIBOR or other benchmark rate, a consumer price index, changes in market rental rates).
- The exercise price of a purchase option if the lessee is reasonably certain to exercise that option.
- Payments of penalties for terminating the lease if the lease term reflects the lessee exercising an option to terminate the lease.
- Fees paid by the lessee to the owners of a special-purpose entity for structuring the transaction.
- Amounts expected to be payable under a residual value guarantee (i.e., in which the lessee guarantees that the leased asset will be at least a specified value at the end of the lease term).
- The incremental borrowing rate to be used or election of the risk-free rate as the practical expedient
- Election of the practical expedient to expense short-term leases (one-year or less)
The lease term comprises the noncancellable period over which the lessee has the right to use the underlying asset period plus periods covered by an option to:
- Extend the lease if the lessee is reasonably certain to exercise that option,
- Terminate the lease if the lessee is reasonably certain not to exercise that option, and
- Extend (or not to terminate) a lease in which the exercise of the option is controlled by the lessor.
Areas Impacting the Manufacturing, Distribution, and Retail Industry
- Leases may include office space rental, vehicles, photocopiers, small machinery, equipment, and embedded leases included in a service contract. Such embedded leases may include:
- Warehouse space, including shared distribution and manufacturing facilities.
- Freight management, transportation, and logistics services.
- Data center spaces.
- Network equipment.
Tips for identifying an embedded lease:
• Determine if more than one customer is using the asset.
• Is it possible to direct how the asset is used?
• Upon termination of the contract, will the other party discontinue the equipment?
• Is a specific asset written into the contract?
- Review general ledger expenses with keywords that can indicate a lease—rent, lease contractor, equipment rentals, subscriptions, etc.
- Inventory is excluded by ASC 842 but included under IFRS 16.
- Be aware that one-year leases that contain evergreen renewal clauses for additional lease terms are not single-year leases and should be evaluated as well.
- Build-to-spec and build-to-suit arrangements pose unique challenges to ASC 842 adoption. In such arrangements, the lessee must recognize the entire project on its balance sheet during the construction of the equipment or plant only if the lessee has control over the asset during construction. Only after the project is done can the arrangement be evaluated under the sale and leaseback guidance. If the lessee does not control the asset during construction, any payments made to the lessor during construction are considered prepaid lease payments.
Stay Tuned and Keep in Touch – Common Control Arrangements
The Financial Accounting Standards Board recently proposed additional guidance related to leases between entities under common control. Highlights of what the FASB is considering are:
- Providing a practical expedient for private companies to use the written terms and conditions of a common control arrangement to determine whether a lease exists and, if so, the classification of and accounting for that lease. If no written contract exists, the entity cannot elect this practical expedient.
- Leasehold improvements would be amortized by the lessee over their economic life, regardless of the lease term, if the lessee controls the use of the leased asset.
Watch for our update once the FASB issues final guidance.
For information on how ASC 842 impacts a financial statement compared to ASC 840, click here.
This new guidance can be nuanced and convoluted, but with the right support from knowledgeable advisors, companies can ensure that they fully understand ASC Topic 842 and remain compliant. The best way to get started is to use the checklist, which can be found here.
If you have questions, contact Marcy Greenfield at 516.806.3425 | email@example.com, Bonnie Mann Falk at 516.806.1193 | firstname.lastname@example.org or your Berdon advisor.