Affects vineyard, production equipment, operating leases
This article was originally published in the April 25, 2016 North Bay Business Journal
The Financial Accounting Standards Board, or FASB, recently updated financial-reporting rules for business leases, potentially making vintners and winegrape growers heavier in assets and liabilities.
Nearly all companies use assets in their businesses, require capital to acquire those assets, and rely on leasing as a way of accessing that capital. Leasing has long been a fundamental part of operating in the wine business – commonly as an alternative way to secure a fruit source when the outlay of capital to acquire a vineyard or reliance on a grower relationship is not practical. Barrels and production equipment are also often leased, allowing companies to use available capital for other purposes and reduce the overall exposure to the risks of ownership. These lease agreements are often entered into with both the lessor and lessee desiring to have the most advantageous arrangement from a cash flow and economic standpoint.
Therefore, many companies work to structure leases in certain ways to achieve a desired financial-statement outcome. Two lease agreements, similar in nature, could be treated differently for accounting purposes. These discrepancies have led to significant changes in how companies are required to account for leases in their financial statements.
Bulking Up the Balance Sheet
In February, the FASB issued Accounting Standards Update No. 2016-02, Leases. The FASB is the designated organization for establishing standards of financial accounting that govern the preparation of financial reports by public and private companies and is the source for generally accepted accounting principles, or GAAP. These standards are important because lender, investor and management decisions are based on credible, accurate and understandable financial information. The objective behind this change is to increase transparency and comparability among organizations as it relates to the recognition and disclosure of leasing activities in financial statements.
Under current GAAP, leases are classified and recognized by lessees as either capital or operating. If a lease is a capital lease, the asset and associated liability is recorded on the balance sheet. If a lease is an operating lease, there is no balance sheet recognition. Rather, the future commitments of that agreement would be disclosed, for example, in the footnotes to a CPA-audited or –reviewed financial statement.
Expense recognition for the two types also varies. Capital lease payments are allocated to amortization and interest expense, and operating lease payments are allocated to rent expense.
Under the new lease model, there are still two types of leases – financing leases and operating leases. But both types of leases result in recognition on the balance sheet by recognizing a right-of-use asset representing the right to use the underlying asset for the lease term and a liability to make lease payments, measured at the present value of future lease payments. When measuring assets and liabilities arising from a lease, the lessee should include payments in renewal-option periods and purchase options, if it is reasonably certain to exercise the renewal or purchase option.
This is a major change! Companies that lease vineyards and production equipment under existing operating leases will have more assets and liabilities on their balance sheets. That changes the way investors and other stakeholders view their overall financial position and has a substantial impact on decision-making.
Recognition Remains the Same
What hasn’t changed significantly is the recognition, measurement, and presentation of expenses and cash flows. For financing leases, a lessee will recognize interest on the lease liability separately from amortization of the asset. Payments on the principal portion of the lease liability are classified within financing activities and payments on the interest portion are classified within operating activities on the cash flow statement. For operating leases, a lessee will recognize a single lease cost, calculated by allocating the total lease cost over the lease term on a generally straight-line basis, and cash payments are classified within operating activities on the cash flow statement. However, disclosure requirements are enhanced and require both qualitative and quantitative disclosures about the timing and uncertainty of cash flows. For operating leases, a lessee will recognize a single lease cost, calculated by allocating the total lease cost over the lease term on a generally straight-line basis, and cash payments are classified within operating activities on the cash flow statement. However, disclosure requirements are enhanced and require both qualitative and quantitative disclosures about the timing and uncertainty of cash flows.
The accounting by the lessor is largely unchanged although there are some minor differences that better align the accounting treatment by lessors with other areas within GAAP.
Three Prep Tips for the Change
The new guidance affects all companies that lease assets and applies to all leases with terms longer than 12 months. For most companies – nonpublic companies – this will be effective for their 2020 fiscal year, but the new rules can be applied early.
While there are still several years to comply, there are some things to consider starting now:
- Evaluate existing resources. Companies may incur additional costs implementing this guidance through employee training, system evaluations, and updating processes and internal controls that align with the new rules. Consult internally with the management team and externally with professional advisers.
- Assess current contracts. Take inventory of existing leases and other contracts and evaluate how they will be impacted by this change. Understand these rules before negotiating new financing.
- Start the discussion. Be transparent with lenders and other stakeholders. Consider the effect on debt covenants and whether changes are warranted. Many financial statement users may already be making adjustments for off-balance sheet obligations.
Contact Michelle Ausburn at MAusburn@bpmcpa.com or (707) 524-6588 for more information.