By Shelby Thorne, CPA

Two of the most significant accounting standards changes the industry has seen in years are just around the corner—and are already impacting the way manufacturers do business this year. Known technically as Accounting Standards Codification (ASC) Topic 842 “Leases” and Topic 606 “Revenue from Contracts with Customers,” the new standards affect both leases and revenue recognition. The new revenue standard is effective for privately owned entities for the annual 2019 calendar year; the new lease standard is effective for the 2020 calendar year. Early implementation is allowed for both.

Is your business ready?

We recommend taking steps now to learn as much as you can about both standards. It’s important to ensure your business is prepared to implement the necessary changes and that you understand how each could impact your external reporting and operating decisions. To help you get started, here are a few things you should know about each new standard.

Happening now: Impacts to revenue recognition

Effective for annual periods beginning after December 15, 2018, the new revenue standard, ASC 606, replaces existing revenue standards and establishes new comprehensive accounting and disclosure requirements for revenue recognition.

The new revenue standard focuses on recognizing revenue upon satisfying performance obligations imbedded in a contract. Generally, these are fulfilled by the transfer of control of goods or services. To determine the appropriate timing and amount of revenue to be recognized, an entity must properly identify the terms within a contract that represent the overall transaction price and performance obligations, and properly allocate the overall transaction price to the identified performance obligations.

The shift in focus to the transfer of control and meeting performance obligations may have a significant impact on the timing of when you recognize revenue. In other words, this could cause you to accelerate or defer revenue.

New focus on the transfer of control of goods or services

Although not all, or any, of the below are necessary to establish whether control has transferred, the new standard lays out five actions that may indicate the transfer of control of goods or services has occurred:

1. The entity has a present right to payment

2. The customer has legal title

3. The customer has physical possession

4. The customer has significant risks and rewards of ownership

5. The customer has accepted the goods or services

Common ways the new revenue standard is impacting our manufacturing clients

  • Point-in-time recognition
    • Manufacturers with single, or limited, performance obligations that have historically recognized revenue upon the shipment of goods or completion of services may not see a significant change in the timing or amount of revenue recognized. However, manufacturers with large-volume customer orders fulfilled over a period of time should look closer to determine if revenue is best recognized over a period of time, as further discussed below in respects to contract manufacturing, rather than at a point in time (at the point of delivery).
  • Over-time recognition and contract manufacturing
    • Entities involved in contract manufacturing will need to evaluate their contracts to determine if revenue should be recognized over time or at a point in time. This determination depends on when control has transferred. If the customer has control of the asset being manufactured, receives benefit as the asset is manufactured, or if there is no alternative use for the manufactured asset and the entity has a right to payment for manufacturing completed to date, the entity may be required to recognize the revenue over time.
  • Warranties
    • Product warranties promising only to replace products that do not function as promised due to manufacturing defects (an assurance warranty) will likely see limited to no changes as a result of the new revenue standards. Entities that offer service warranties (i.e., extended repair warranty), or a combination of product and service warranties, will likely need to account for the service warranty portion of the contract as separate performance obligations. This would require the entity to allocate a portion of the overall transaction price to this obligation.
  • Selling through a distributor
    • Revenue previously prohibited from recognition due to the price not being fixed or determinable as a result of a right-of-return clause or significant risk of price concessions (both are common conditions when selling through a distributor) may now be able to be recognized earlier upon the transfer of control to the customer or distributor. Although acceleration of revenue may be possible, the amount of revenue to be recognized is also impacted by variable considerations (e.g., right-of-return or estimated price concessions) that are probable to occur (most likely not to be reversed in the future) when determining the overall the transaction price.

Implementation guide: What actions should you take?

Understand and assess the impact the new standard has on your business. Management should assess the potential impact of this standard in each of its significant classes of customer contracts or revenue streams. Having a thorough understanding of the new standard can not only help you determine the proper recognition of revenue but can also lead to the accurate modification of contracts to best fit your company’s ideal recognition model.

Initial application/transition entities are required to recognize the impact of this guidance retrospectively. This means management is tasked with determining the best revenue recognition approach for the current period (starting for calendar year 2019) and in future years while also applying the new standard to prior periods that are presented in the entity’s external reporting (commonly calendar year 2018).

Management should consider other areas that could be impacted by the new revenue standard. These could include debt covenants, income taxes, key performance indicators, and other revenue-based metrics, such as commissions calculations.

Happening next year: Impacts to leases

Effective for annual periods beginning after December 15, 2019, under the new lease standards, ASC 842, essentially all new and existing leases, with the exception of short-term leases (i.e., 12 months or less), must be recognized on your company’s balance sheet.  Prior to this update, leases classified as operating leases were not included on the balance sheet. Overall accounting for a lessor remains relatively unchanged, although some changes were made to align with lessee guidance.

From a lessee perspective, the most significant impact many entities will see relates to how long-term operating leases are presented on the balance sheet. Accounting for capital leases, now coined “finance leases,” remains relatively unchanged. The income statement impact as it relates to operating leases, in many cases, will remain relatively consistent with how lease expense was previously recognized. Below is a summary of how each lease arrangement is recognized under the new standard.

Finance lease (formerly “capital lease”)

Balance sheet treatment: Recognition of a right-of-use asset and a lease liability measured at the present value of unpaid lease payments.

Income statement treatment: Separate recognition of interest expense and amortization expense of the right-of-use asset.

Operating lease (term greater than 12 months)

Balance sheet treatment: Recognition of a right-of-use asset and a lease liability measured at the present value of unpaid lease payments.

Income statement treatment: Recognition of a single lease expense, generally recognized on a straight-line basis. This single lease cost is made up of a combination of interest incurred on the resulting lease liability and amortization of the right of use asset.  Due to the many elements in calculating the straight-line expense, it may or may not equal the actual amount paid on a monthly basis.

Common ways the new lease standard is impacting our manufacturing clients

Leasing decisions: To lease or to buy? Short-term or long-term?  

The benefits of the off-balance sheet presentation of long-term operating leases has been eliminated.  As a result, management should adjust its approach to accepting the terms of a lease contract accordingly. Both financial reporting and tax reporting should continue to be considered. Elements of a lease vs. buy decision from a tax standpoint remain unchanged.

Loan covenants

Financial ratios related to liabilities, such as debt to equity and debt service coverage, will be impacted by the amount of liabilities brought on the balance sheet from operating leases. Additionally, the classification of the current portion of lease liabilities will impact ratios such as the current ratio and working capital.

Embedded leases within a contract 

The definition of a lease under the new standard is a contract, or part of a contract, that conveys the right to control the use of an identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration. A contract may contain a lease if it conveys the right to control a specific asset, even if the original intent wasn’t to create a lease agreement. Arrangements such as contract manufacturers (e.g., dedicated tooling), complex service contracts (e.g., specified equipment), or transportation and delivery services (e.g., delivery vehicles) may contain elements of a lease.

For example, if a business contracts with an entity to manufacture a highly specialized product using a dedicated production line, the contract manufacturer is contractually unable to use the production line for any other use, and the production schedule is relatively fixed, this situation may represent an embedded lease to lease the equipment used in the production line.

Implementation guide: What actions should you take?

Understand and assess the impact the new standard has on your business. Management should assess the potential impact of this standard in order to properly account for leases and making leasing decisions. Management should also gain an understanding on the impact the standard has on banking covenants.

Compile a schedule of all leasing arrangements including a description of relevant lease terms and management’s judgment in determining proper accounting.

Initial application/transition entities have two options for recognizing the impact of this guidance: 1) Retrospectively, by adjusting all presented prior periods for its impact, or 2) by electing an alternative approach that only adjusts the current period and recognizing the impact on prior periods through an adjustment to retained earnings in the current period. All private entities must implement the new leasing standard starting in calendar year 2020.

We’re here for you

Whether it’s jumping on a quick phone call to provide guidance, helping you track your leasing activities, or a taking a comprehensive dive into the elements of your leasing contracts, we’re here to help. Together, we’ll determine the best approach for your business.