In February 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2016-02, Leases, which provides new guidelines that change the accounting for leasing arrangements.
The new leasing standard is required to be adopted in 2019 for calendar year-end public business entities and the following fiscal year for all other entities. Early adoption is permitted at any time, which might be desirable for some.
Significant Impact on Transportation and Logistics
The new standard primarily changes accounting guidance for lessees to now require operating lease assets and lease liabilities to be recorded on the balance sheet, with an accounting policy option to exclude those leases with a maximum lease term of 12 months or less from balance sheet recognition. This significantly differs from legacy accounting for operating leases, under which they were viewed as executory contracts, often referred to as “off-balance-sheet.”
In its 2005 US Securities and Exchange Commission report, SEC staff estimated that there were approximately $1.25 trillion in off-balance-sheet operating lease obligations. These weren’t recognized on issuer balance sheets but were instead disclosed in the notes to the financial statements. Adjusted for inflation, the amount was about $1.54 trillion in 2016.
Here are a couple of examples that show how the new standard will significantly impact some companies in the transportation and logistics industry.
UPS, the nation’s largest for-hire carrier, reported the following in its 10-Q filed for the quarter ended September 30, 2016: “This new guidance requires modified retrospective application and becomes effective for us in the first quarter of 2019, but early adoption is permitted. We are currently evaluating this update to determine the full impact of its adoption on our consolidated financial position, results of operations, cash flows and related disclosures. We expect material changes to our consolidated financial position.”
There will indeed be material changes because UPS’s operating leases, which include aircraft, facilities, land, equipment, and vehicles, amounted to $1.26 billion in future contractual obligations as of December 31, 2015, as reported in the company’s 10-K filed for the year ended December 31, 2015.
FedEx, the nation’s second largest for-hire carrier, also recognized in its 10-Q filed for the quarter ended November 30, 2016, that the lease liability and related right-of-use asset will significantly impact its balance sheet.
At November 30, 2016, while its future minimum lease payments under capital leases were immaterial, those under noncancelable operating leases—mainly aircraft and facilities—amounted to $17.8 billion, which is about 35 percent of the company’s annual fiscal-year 2016 revenue.
The company also disclosed that in accordance with US generally accepted accounting principles (GAAP), these future contractual payments aren’t recorded in its balance sheet, and the majority of these leases will be required to be recognized at the present value on the balance sheet as a liability with an offsetting right-to-use asset under the new lease accounting rules. FedEx has indicated that credit rating agencies routinely use information concerning minimum lease payments required for FedEx’s operating leases to calculate the company’s debt capacity.
Evaluate Your Leases
It’s important to evaluate your leases, assess the operational impacts, determine potential tax consequences, and assess whether there are potentially any benefits of early adoption that may apply to your company.
It isn’t always straightforward. The new standard defines a lease as “a contract, or part of a contract, that conveys the right to control the use of an identified asset for a period of time in exchange for consideration.” To meet this definition, the contract may identify the specific property, plant, or equipment either explicitly or implicitly.
This means that there’s some judgment that’s necessary when determining if two criteria—an identified asset and customer control—are included in the contract. When these two criteria are combined with the transfer of consideration, the new standard requires the arrangement to be accounted for as a lease. Below, we’ll take a look at a few common examples of areas where judgment is required.
Identified Asset Example
Transportation contracts may explicitly or implicitly specify the exact vessel, rail car, or truck to be used. For example, a contract would implicitly identify the equipment in the contract when the owner of the asset has no practical alternative equipment that can be used to fulfill the agreement, even if the contract doesn’t explicitly state which specific piece of equipment will be provided.
In this scenario, the contract would be (or contain) a lease if the contract met the other criteria in the definition of a lease; that is, the customer can control the use of the transportation equipment and is required to transfer consideration to the supplier of the equipment, even though the specific piece of equipment isn’t explicitly listed in the contract.
Customer Control Example
Company A enters into a contract for the exclusive use of a cargo ship for a three-year period for a fee. The supplier, Company B, is required to provide an explicitly identified ship and doesn’t have substitution rights to use another ship. Company B operates and maintains the ship; however, Company A decides what cargo will be transported on the ship operated by Company B as well as the dates and cities the ship will sail to for the load and off-load of the cargo.
In this scenario, the contract contains a lease as all of the lease criteria are met:
- There’s an identified asset.
- Company A has the right to control the ship through exclusive use over the three-year period as well as the right to direct the ship—which cargo will be carried, where the ship will arrive, and when.
- Company A is obligated to pay Company B a fee for the use of the ship.
In contrast, changing some small details within a contract could result in a contract no longer being considered a lease.
Assume the same facts above with the exception that the contract specifies the cargo that will be transported and the location and dates Company B is expected to have the ship at for the loading and off-loading of Company A’s cargo. While Company A doesn’t have the exclusive use of the cargo ship or rights to control the use of it in this scenario, the ship is still explicitly specified. Since Company A doesn’t have any further decision-making rights as to the use of the ship during the contract term, it’s determined to not have control of the specified asset and the arrangement is therefore not a lease.
Today, as incredible momentum takes place across the transportation industry—including groundbreaking automated vehicle technology, electric vehicles, and charging infrastructure, renewable diesel and natural gas technologies, and roll-out of EPA Phase 2 regulations—new capital investments and leasing will be an inevitable part of staying in the game.
Green Fleet Systems, which serves various business sectors that use the Ports of Long Beach and Los Angeles in California, is one of the leaders in embracing this new normal. They’re committed to being one of the first so-called green trucking companies operating clean burning, environmentally friendly fuel trucks.
BNSF Railway and Daylight Transport are other examples of companies that embrace new technology. They both operate zero-emissions, electric-powered, heavy-duty vehicles—BNSF Railway at its intermodal rail yards in the California cities of San Bernardino and Commerce and Daylight Transport out of its new truck freight transfer facility in Fontana.
With these historical investments into new technology and infrastructure, there’s a case to be made that users of financial statements can more easily compare companies that own their productive assets with those that lease their productive assets as a result of the new lease accounting guidance. This is because operating lease obligations will no longer be left off balance sheets.
We're Here to Help
This new standard will impact most businesses in one form or another. If you have questions about how to implement the new accounting standard or how it will affect your business, you can find more information and examples in ASC Topic 842, Leases: The FASB’s New Guidelines and Their Effect on Leasing Arrangements or contact your Moss Adams professional.