You may have heard of the updated lease accounting standard, but as a business owner, it wouldn’t be a stretch to assume you might not have given it another thought if you’d heard of it all. If you’re unfamiliar with ASC842 and wondering if it impacts you, this piece is highly beneficial and worth a read!
Introduction to ASC842 and the impact on Wineries
ASC842 came into effect in 2019 and 2020. Due to delays arising from COVID-19, the FASB deferred the effective date for private entities with fiscal years beginning after December 15, 2021. Therefore, all entities should have adopted and integrated the standard into their financial statements.
The new standard was introduced to effectively enhance a company’s financial transparency by showing its obligations in terms of its leases. In other words, it aims to paint a clearer picture of what your future expenses, in relation to things like rent, would be, where you’ve signed lease agreements locking you in for a period of time.
The leasing standard most certainly impacts wineries as well, as common types of leases we see within wineries would be rental leases for tasting room spaces, vineyards, and production facilities. In addition to property rental, you’re also likely to encounter the leasing of barrels, which are leases undertaken to ease up cash flow.
Is Your Company Subject To Lease Accounting?
There are a couple of questions you need to consider when trying to ascertain whether you are, in fact, subject to lease accounting:
- Are you engaged in rental contracts where you receive the right to use an asset in exchange for frequent (usually monthly) payments?
- The most common example of this would be if you rent a premises as a tenant and have an agreement with the landlord to make monthly payments for a specified period.
- Is the contract for a period longer than 12 months?
- This is a crucial point to consider when analyzing your contract, as there is an option not to recognize short-term leases on the balance sheet. You should be able to continue as usual and recognize the payments as a rental expense on your income statement.
You are subject to lease accounting. What next?
There are two types of leases that you could have on your books:
- Finance or Capital Leases
- Operating Leases
Depending on the nature of the contract you’ve signed, you may be leasing an item to own it at the end of the term (rent-to-own), or you could have the option of purchasing the asset for a nominal value at the end of the lease term. In addition, the asset you’re leasing may be of such a specialized nature that it would be of little use to the lessor at the end of the lease term. These considerations establish what the type of lease it is. Another way to establish what type of lease it is is by identifying who ultimately has true ownership of the underlying asset. If it’s the lessee, this will be classified as a capital lease.
On the other side of the classification, if you answered no to all of the above, the substance of the lease agreement is that you’re using an asset for a period of time that you’ll be returning to the lessor at the end of the lease term. In short, you’re renting the asset and not consuming all of its economic value (a great example is leasing a premises – you’ll be returning it to the landlord, who can rent it out to another tenant once your lease contract Is up). These types of leases are classified as operating leases.
Capital Lease vs Operating Lease Treatment
While both leases end up on your balance sheet as a right-of-use asset (ROU) and a right-of-use liability, there are nuances in how the monthly lease payments are treated and disclosed in your financial statements.
Upon initial recognition, capital lease treatment requires you to raise a right-of-use asset at the lease liability amount (including initial direct costs and prepaid lease payments, less any lease incentives received). The lease liability is measured at the present value of the unpaid lease payments. This means you’ll be calculating what the present value of the lease payments set out in the contract term is using a discount (interest) rate that is either stated in the lease or, if the rate cannot be readily determined, the discount rate will be your company’s incremental borrowing rate.
For operating leases, the initial recognition is the same as that of capital leases. The deviation between the two leases comes in with a subsequent measurement.
For capital leases, the right-of-use asset on your balance sheet will be amortized on a straight-line basis to the earlier of the end of its useful life or the lease term. The ROU liability will be decreased by the lease payments made and increased by the interest calculated using the effective interest method. Your income statement will reflect two expenses: the amortization expense on the ROU asset and the interest expense of the ROU liability.
For operating leases, the ROU asset will be amortized by the difference between the period straight-line lease cost and the periodic interest accretion. The ROU liability will be treated the same as that of a capital lease, increasing by the interest on the lease and decreasing by the lease payments made. Your income statement will only reflect one expense, a single lease cost, which is generally on the straight-line basis.
Some of the most common considerations when approached with lease accounting include, but are not limited to, whether the contract has lease and non-lease components. A non-lease component is an element within the contract unrelated to using the leased asset. An excellent example of this would be with rental property, where the contract could include components relating to services contracts and standard area maintenance (CAM). It’s essential to be aware of this, as when you’re establishing your lease, you need to look at the lease components.
Another consideration is the option to renew your lease. Many contracts include an option to renew, which needs to be taken into account upon initial measurement of your lease. The basis of consideration would be whether you intend on renewing, and ultimately, the lease term you use for calculating your present value will include the extended period if it’s reasonable and likely that you will exercise the option to do so.
There is also the consideration of rent-free periods, which can be offered to the lessee. Even though you may be offered a rent-free period (granted early access to your rental property), the present value of your lease liability will still consider the total rental payments you’re going to make over the full lease period. While you won’t make payments for that rent-free period, you’ll still incur a lease expense as determined by your subsequent measurement discussed above.
In the wine industry, intercompany rental is common, with wineries leasing their vineyards to a related company. Leases between related parties should be treated the same as all other leases, with special consideration given to the requirement that intercompany transactions between related parties should meet what is known as the “arms-length” standard. This generally means that such transactions should be priced similar to how transactions would be priced with unrelated parties.
What Your Accountant Needs From You
To start with, you’d need to provide all your lease contracts that are in place. This provides the basis for starting your assessment of whether you are subject to lease accounting and determining the types of leases you may have. For contracts that include options to renew, your accountant will need to know whether you intend to utilize the extensions or not.
Should you have several leases (let’s say a few properties, but you also engage in the rental of equipment, etc.), you may want to consider the need for specialized software. Plenty of options are available within this space, especially since the adoption of ASC842, and this software will automate the process of recording leases and prepare amortization schedules for you.
Let Protea Financial Help You with Your Leases
Protea can help you from start to finish within the assessment process and record the leases within your financial statements. Not only will you get financial statements compliant with the relevant regulations and tax laws, but you’ll also get a clearer picture of your company’s obligations in terms of future lease payments you’re subject to. This further enhances your understanding of your financial position’s effects on your business and will allow you to make sound decisions regarding matters such as financing and expansion.