New Lease Accounting Standards will Impact Your Winery
Executive Summary
Effective January 1, 2022 new lease accounting standards will change the look of your GAAP (generally accepted accounting principles) financial statements.
Previously, operating leases showed up only as an expense on your income statement. Now your balance sheet is going to also reflect a right-of-use asset and and a liability equal to the present value of the lease payments. The right-of-use asset and the related liability will decrease over the term of the lease.
This dual treatment (where the item appears on both the income statement and balance sheet) will change certain key financial ratios.
Debt Service Coverage
The main concern is the impact this new treatment will have on your bank loan covenants. Often, banks will require a certain level of debt service coverage (Net Operating Income/Current Debt Obligation for a period). It usually requires earnings to be sufficient enough to cover some multiple of future debt payments.
With operating leases now added to the balance sheet, their related payments will become part of this future debt and will increase the denominator of the equation, thereby lowering the ratio. Missing this covenant (due to a lower ratio) could lead the bank to increase their interest rate.
The following information covers the complexity of this new standard and how it will affect winery and vineyard entities.
Even if you are not required by your lender to have compiled, reviewed or audited financial statements, your bank loans may require your financial statements to be prepared in conformity with GAAP and therefore subject to these new rules.
Return on Assets
In the wine industry, return on assets (net income/assets or ROA) is not usually monitored too closely, but this new accounting method will also decrease this important ratio.
Click here to watch a brief video that explains these concepts and the impact on key financial ratios.
A Deeper Look
Beginning in 2022, financial statements prepared in accordance with generally accepted accounting standards will have to report traditional operating leases much differently. Capital leases will be reflected as finance leases and pages of disclosures will be required.
The accounting rule-setting body is requiring these changes to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and through increased disclosures of key information about leasing transactions. That said, the computations are complex and unless you’re a math and Excel wizard, you will need specialized software to determine what to record and disclose.
The following is a brief overview of how your financial statements will change and how this may impact your current bank loan covenants which could impact the cost of financing.
To get sense of the complexity involved, the updated standard is 46 pages and we have seen analysis done that resulted in over 1,200 pages of interpretation and explanation of how those 46 pages are to be implemented. You grow the grapes and make marvelous wines and our job is have the finance side of your business make sense and be useful to you.
The big change is operating leases will no longer be a disclosure of future payment obligations in your financial statements. Instead, they will show up on your balance sheet as an asset and liability. Why should you care? In particular, the new liability could trigger a loan covenant violation.
The following are examples of how leases will be reflected in your financial statements:
Equipment Operating Lease
Assumptions
Equipment Lease Term 36 months
Monthly Payment $ 1,500
Discount Rate 5%
Lease Commencement
Right-of-Use Asset ( DR ) $ 50,049
Lease Liability ( CR ) $ 50,049
End of First Year
Lease Expense $ 18,000
Lease Liability $ 15,858
Right-of-Use Asset $ 15,858
Cash $ 18,000
Unlike a finance lease, no interest or depreciation is recorded for an operating lease. This example has been simplified. In actual practice, the current portion of the lease liability would need to be updated annually.
This is one of the areas that could lead to a loan covenant violation if your existing loan agreement uses the debt coverage ratio since a portion of lease payment above would become part of the next year’s debt coverage that would need to be met. With the debt obligation increasing you would need more income available to “cover” the lease debt.
Equipment Finance Lease
Lease Commencement
Right-of-use Asset $ 50,049
Lease Liability $ 50,049
End of First Year
Amortization Expense $ 16,683
Interest Expense $ 2,142
Lease Liability $ 15,858
Right-of-use Asset $ 16,683
Cash $ 18,000
Vineyard Lease
Assumptions
Vineyard Lease Term 20 years
Annual Payment $ 200,000
Discount Rate 4%
Accounting for agriculture leases has become quite complex because the rules have created a definition of lease and non-lease components. As such, irrigation, trellis and land are lease components, and the vines are non-lease components. What this means is the portion of the lease payment attributable to the vines is excluded from the lease rules and would be treated as rent expense. However, unless you can determine the portion of the lease payment that is attributable to each of these components you will need to elect and alternative accounting method which allows you to include the vines as a lease component. We have found that often the winery is responsible for the vineyard development cost and thus the lease is really for the use of the land which would fall under the classification of a right-of-use asset.
Lease Commencement
Right-of-use Asset $ 2,810,319
Lease Liability $ 2,810,319
End of First Year
Amortization Expense $ 200,000
Lease Liability $ 93,652
Right-of-use Asset $ 93,652
Cash $ 200,000
* * * * * * * * * * * *
FAQ’s
1. What about a multi-year grape contract that is based on a fixed rate per ton where the grapes will be used in the production of wine for future sale?
In this example, the grapes being purchased will eventually become inventory of the buyer. Inventory is specifically exempt because is not considered a right-of-use asset (i.e. equipment, land, trellis, etc.). Thus, the grape purchases will not be treated as a right-of-use asset.
2. The winery leases a storage facility from a related party. Is this subject to the right-of-use asset lease rules?
Yes, this would be like accounting for the equipment lease discussed earlier. The fact that it is between related parties will not matter for lease accounting.
3.The winery has an agreement that renews annually to utilize 15 acres of vineyards. The winery is responsible for all the faming costs and any vineyard replacement costs. Would this be subject to lease rules since it is not a long-term agreement?
In certain circumstances when a lease is for less than 12 months, the lease rules do not apply. However, if the intent of the lessee is to utilize the vineyards beyond one year or the lessee has a significant investment in the leasehold improvements, or the grapes are considered an integral part of its winemaking production then the right-of-use asset and liability would be recorded.
4. The winery leases its barrels. Through 2021 the lease has been considered a capital lease, so the barrels were recorded as and asset along with the related long-term liability. Would this change under the new rules?
The capital lease would be treated as a finance lease and basically be treated the same. If future leases were determined to be operating leases, then a right-of-use asset and related liability would be recorded.
5. The winery has several custom crush contract clients. Does a custom crush agreement fall under the new lease requirements?
If you do not have the right to control how the winery’s assets are to be used, then the agreement would be considered a service contract and would not be subject to the lease standards.
Preparing for the Impact
As you can see there are many different items that can trigger the new lease rules. Here are recommended actions to take:
- Talk with your CPA firm to see if they can guide you through the process.
- Find out if your lending institution is aware of the new lease rules and if it will impact your loan covenants. The easiest solution is for the lender to accept a modified GAAP financial statement that would exclude the application of the new lease standards. Even if you are not required to have your CPA firm prepare financial statements for the lender, often the loan agreement will state that the financials need to be in conformity with generally accepted accounting principles (GAAP), which means the new lease standards would need to be applied.
BDCO offered free training on 7/13 to bankers who need to understand these new rules and their impact on wineries. You can watch the recorded video on our website here.