Supply arrangements can sometimes be considered leases for accounting purposes. PwC’s Chuck
Melco discusses how to identify arrangements that may be considered leases, how reflecting them
as leases can affect your financial statements and footnotes, along with the impact the new leasing
standard will have on this area.
Hi, I’m Chuck Melko.
Companies often enter into long-term contracts with suppliers. What is often less well known, is that some of these contracts may actually be considered leases for accounting purposes.
In this video, I’ll share the guidance for looking at long-term supply contracts through the lens of lease accounting under the current standard. And further, I’ll explain how the new lease standard makes getting this area right even more important. So the place to start is identifying what types of contracts need to be assessed.
A supply arrangement typically falls within the scope of the leasing guidance when there is a dedicated asset or a component of an asset that is used to fulfill the arrangement. So say you have a supplier and they have a factory or a line of equipment where you are the sole customer. The accounting guidance may view you as the lessee of that asset. It may also trigger lease accounting if you have control or decision making rights, such as adjusting production schedules. If a supply contract is determined to be a lease, you will see impacts to the income statement and disclosures, and potentially to the balance sheet as well.
For the income statement, in the case of an operating lease, the pattern of recognition changes from recognition based on delivery of the product to reflect a straight-line of the minimum lease payments. In the case of a capital lease, the pattern of recognition would be a front-loaded interest expense and a straight-line amortization of the capital lease asset. In the footnotes, disclosures for commitments under a supply contract change to disclosures of lease obligations. And lastly on the balance sheet, in an operating lease there may be deferred lease expenses related to the straight-line expense calculations and if you determine it’s a capital lease, you would need to recognize a capital lease asset and related obligation.
Now what can happen is, a company may inappropriately conclude a contract is not a lease, and because it may have been an operating lease, the impact isn’t material. However, under the new leasing standard, this area of accounting will take on a new level of importance. As you may know, under the new leasing standard, virtually all leases will go on the balance sheet. So identifying these contracts as leases is key to getting your balance sheet right, but there is another change I would highlight.
A contract will be a lease under the new guidance if there is an identified asset in which the purchaser has control. Under the current guidance, a contract may be a lease if substantially all of the output is being obtained by the customer. This type of arrangement would not convey control under the new guidance and therefore would not be a lease.
In addition to those impacts, changes to balance sheet recognition could impact various financial statement ratios and potentially debt covenants.
In closing, it’s important that you look at current agreements now to ensure all leases are identified. It will also be important to understand the new lease rules when new contracts are being negotiated as there may end up being a substantial impact to the organization’s financial statements.
For more information on this topic, refer to PwC’s lease accounting guide available on CFOdirect.com.