Companies, including manufacturers, are feeling the impact of new lease accounting standards this year, with lease liabilities rising sharply, according to accounting technology provider LeaseQuery.
The new standard is known as ASC 842. The standard was devised because of Enron, an energy company involved in accounting fraud, according to Accurent. "At its height, Enron was a much riskier company than its published financial statements indicated in 2001," the website said.
Sarah O'Sullivan, LeaseQuery accounting director, discussed ASC 842's impact on manufacturing in an email interview with SME Media.
QUESTION: What changed with the new lease accounting standard? How did it cause an increase in liabilities on manufacturing balance sheets?
SARAH O'SULLIVAN: The new lease accounting standard, ASC 842, has significantly changed how companies account for and report their leases under US GAAP. One of the primary motivations for establishing this new standard was to increase transparency into financial statements by requiring organizations to provide more information and insight into an entity’s lease obligations.
For the first time, companies are now required to present most of their operating leases on the balance sheet in the form of a right-of-use asset and lease liability.
Operating leases have been widely used across many companies and industries as a way to obtain the assets needed to meet business goals without expending significant cash (or take on debt) immediately by purchasing those assets. With so many operating leases currently in existence, the impact of reflecting them on the balance sheet all at once has caused significant increases in liabilities balances.
As we’ve seen, the manufacturing industry has seen an average increase in total liabilities of 2.5x directly related to the adoption of ASC 842. This is no surprise given that manufacturing companies use operating leases for a variety of assets including warehouse space, forklifts, vehicles, computers, and other miscellaneous equipment to support their production activities.
In addition, the added importance of properly including all operating leases on the balance sheet means that embedded leases have come under greater scrutiny. These types of leases are typically found within purchasing and service agreements, specifically when a customer receives the right to use and control identified assets as part of the arrangement, and often require judgment and careful consideration to identify them.
For example, warehouse space is an area that manufacturing companies will want to pay attention to; fully understanding the terms of their storage/inventory space arrangements with third parties is critical to concluding whether those arrangements result in an actual lease rather than just services.
QUESTION: What manufacturing organizations have been most affected? Is it certain types of industries?
O'SULLIVAN: The largest impacts are felt by organizations that have extensive operating lease portfolios. Not only will organizations with heavy leasing activity see noticeable increases to their liability balances, but they will also find that adopting the new standard can be more complex than expected. Many companies that have already adopted the new rules have reported back that implementation generally was more challenging and took more time than originally anticipated.
As part of adopting ASC 842, companies need to identify a complete and accurate listing of all of their existing operating leases. Manufacturing companies, especially those with multiple production facilities across multiple geographies, often have a large quantity of leased assets that include vehicles, forklifts, and smaller equipment.
While these lease arrangements might have lower dollar values individually, the time and organization it takes to properly identify them all and apply the new accounting rules can be significant. Companies that currently have a centralized procurement and supply chain function will likely have a head start on compiling a full inventory of operating leases while those with a more decentralized process might be compiling lease contract data for the entire organization for the first time. However, all companies will want to perform thorough reviews of their contracts and general ledgers (e.g., rent expense) to ensure they don’t miss any material leases.
QUESTION: How should manufacturers respond?
O'SULLIVAN: The best advice for responding to the demands of the new lease accounting rules is to start now. The implementation process requires organization and collaboration across multiple departments within a company.
While the accounting and finance teams will have the direct responsibility for implementing the new accounting and reporting procedures, they will rely on their colleagues around the organization to help them identify leases and ensure their understanding of all critical contract terms.
Company departments that are typically involved in the implementation process include Supply Chain, Procurement, Legal, Treasury, and Financial Planning & Analysis.
The first step towards the successful adoption of ASC 842 is to design a project plan to manage the process. Companies will want to think through who needs to be involved in the project, whether a software tool will be used to manage the accounting, what training is needed for employees, and so forth.
Another important factor to remember is that the impacts and efforts don’t stop at initial implementation. Don’t forget about “day two” impacts such as designing new financial reporting processes and controls to properly comply with the new accounting and disclosure rules on a go-forward basis.
QUESTION: What happens next?
O'SULLIVAN: Public companies have already adopted ASC 842 and many have now entered their second or third year reporting under the new standard. Companies that are currently in their implementation process can leverage their public counterparts’ experiences by reviewing feedback on best practices and tips.
These resources can help companies successfully transition to the new rules. In addition, companies should be considering the broader impacts that ASC 842 will have.
For example, consider how the increase to liabilities on the balance sheet affects financial ratio analysis and debt covenant requirements and whether any steps need to be taken to prepare for those changes. Project teams can start preparing internal and external stakeholders in advance to help them understand what impacts they’ll see and what they need to know.
QUESTION: How does change with the lease accounting standard tie in with other manufacturing trends (Industry 4.0, etc.)?
O'SULLIVAN: Adopting ASC 842 is a major undertaking, but there are also benefits that might not be immediately evident and can be particularly helpful for organizations in the current economic environment.
By centralizing lease data, companies are gaining a better understanding of their lease portfolios, helping them to analyze operating costs and identify opportunities for savings. A more complete view of their leasing activity allows for more accurate forecasting and budgeting and can highlight where inefficiencies exist.
When companies strengthen their knowledge of their organization’s leasing activities, they are able to make more informed procurement decisions that can directly boost the bottom line. As the economy continues to emerge from the pandemic, manufacturing companies with in-depth knowledge of the financial impacts of ASC 842 are better prepared to respond to changing consumer demands and optimize their financial results.