The updated lease accounting standard is currently in effect for private companies. After several postponements during the pandemic, the Financial Accounting Standards Board (FASB) voted unanimously to move forward with the changes. That means private companies and private not-for-profit entities that follow U.S. Generally Accepted Accounting Principles (GAAP) must adopt the new standard for fiscal years beginning after December 15, 2021, and interim periods within fiscal years beginning after December 15, 2022. Surprisingly, some organizations still haven’t completed the implementation process, however. (Note: The updated accounting rules for long-term leases took effect for public companies in 2019.)

In a nutshell

Under the updated guidance, organizations must report both operating and finance leases on their balance sheets (with the exception of short-term leases with terms of 12 months or less). Previously, operating leases didn’t have to be recorded on the balance sheet.

This means lessees must now record a “right-to-use” asset and a corresponding liability for lease payments over the expected term. Generally, the asset and liability are based on the present value of minimum payments expected to be made under the lease, with certain adjustments. The updated guidance also requires additional disclosures about the amount, timing and uncertainty of cash flows related to leases.

How will these changes affect your organization’s financial statements? The effects vary, but if you have significant operating leases for buildings, equipment, vehicles, technology and other assets, adopting the updated standard will immediately increase your company’s assets and liabilities, making it appear to be more leveraged than before. This can cause technical violations of loan covenants that limit your debt or require you to maintain certain debt ratios. You might want to forewarn your lenders if you expect major changes to your year-end financial results under the updated guidance.

A major undertaking

Based on our experiences with public companies and other organizations that have already implemented the updated lease standard, the biggest challenge will be to locate all of your leases and extract the data necessary. Leases generally aren’t standardized, so reviewing them and gathering the required data — including lease terms, payment schedules, end-of-term options and incentives — can be a time-consuming, manual task.

Another challenge will be identifying leasing arrangements that must be accounted for under the updated standard but aren’t found in traditional lease agreements. If an agreement gives you the right to control an identified asset for a period of time in exchange for payment, then it may be considered a lease under the updated guidance. For example, leases may be “embedded” in service, supply, transportation or information technology agreements. With embedded leases, you’ll need to separate the contract’s lease and nonlease components for reporting purposes.

Leverage external resources

Organizations with significant leasing arrangements might want to consider purchasing lease accounting software to automate the process of managing and tracking their leases and calculating their lease-related assets and liabilities. If you haven’t yet started the implementation process, we can help you evaluate software options and get your accounting records and systems up to speed. Contact us for more information.

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In the spirit of Independence Day, it’s a good time to review the rules for auditor independence. If you discover potential issues now, there’s still plenty of time to take corrective action before next year’s audit begins.

Definition of independence

Independence is one of the most important requirements for audit firms. It’s why investors and lenders trust CPAs to provide unbiased opinions about the presentation of a company’s financial results. The AICPA and the Securities and Exchange Commission (SEC) have rules regarding auditor independence. Even the U.S. Department of Labor has issued independence guidance for auditors of employee benefit plans.

The AICPA specifically goes to great lengths to explain how audit firms can maintain their independence from the companies they audit. In short, auditors can’t provide any services for an audit client that would normally fall to the company’s management to complete. Auditors also can’t engage in any relationships with their clients that would 1) compromise their objectivity, 2) require them to audit their own work, or 3) result in self-dealing, a conflict of interest or advocacy.

Independence is a matter of professional judgment, but it’s something that accountants take seriously. A firm that violates the independence rules calls into question the accuracy and integrity of its clients’ financial statements.

Prohibited services

Under Rule 2-01 of Regulation S-X, the SEC specifically prohibits auditors from providing the following nonaudit services to a publicly traded audit client or its affiliates:

• Bookkeeping,
• Financial information systems design and implementation,
• Appraisal or valuation services, fairness opinions or contribution-in-kind reports,
• Actuarial services,
• Internal audit outsourcing services,
• Management functions or human resources,
• Broker-dealer, investment advisor or investment banking services, and
• Legal services and expert services unrelated to the audit.

This list isn’t exhaustive. Audit committees should consider whether any service provided by the audit firm may impair the firm’s independence in fact or appearance. SEC independence rules also prohibit audit firms and auditors from engaging in financial relationships with their public audit clients, such as contingent fees, banking, insurance, debtor-creditor arrangements, broker-dealer relationships and futures commission merchant accounts.

In the spotlight

In a recent statement, the SEC’s Acting Chief Accountant Paul Munter noted that current market conditions have caused many companies to engage in complex business arrangements, including restructurings and special purpose acquisition companies. “Such arrangements have the potential to undermine auditor independence. The [general standard of independence, Rule 2-01(b)] is the heart of the Commission’s auditor independence rule, it always applies, and the Commission investigates and enforces against violations of the general standard,” said Munter.

Independence is a critical issue for public and private companies alike. Contact your auditor to discuss any questions you may have regarding auditor independence.

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Recent supply shortages may cause unexpected problems for some businesses that use the last-in, first-out (LIFO) method for their inventory. Here’s an overview of what’s happening so you won’t be blindsided by the effects of so-called “LIFO liquidation.”

Inventory reporting methods

Retailers generally record inventory when it’s received and title transfers to the company. Then, it moves to cost of goods sold when the product ships and title transfers to the customer. You have choices when it comes to reporting inventory costs. Three popular methods are:

1. Specific identification. When a company’s inventory is one of a kind, such as artwork or custom jewelry, it may be appropriate to use the specific-identification method. Here, each item is reported at historic cost and that amount is generally carried on the books until the specific item is sold.

2. First-in, first-out (FIFO). Under this method, the first units entered into inventory are the first ones presumed sold. This method assumes that merchandise is sold in the order it was acquired or produced. Thus, the cost of goods sold is based on older — and often lower — prices.

3. LIFO. Under this method, the last units entered are the first presumed sold. Using LIFO usually causes the low-cost items to remain in inventory. Higher cost of sales generates lower pretax earnings as long as inventory keeps growing.

Downside of LIFO method

LIFO works as a tax deferral strategy, as long as costs and inventory levels are rising. But there’s a potential downside to using LIFO: The tax benefits may unexpectedly reverse if a company that’s using LIFO reduces its ending inventory to a level below the beginning inventory balance. As higher inventory costs are used up, the company will need to start dipping into lower-cost layers of inventory, triggering taxes on “phantom income” that the LIFO method previously has allowed the company to defer. This is commonly known as LIFO liquidation.

Retailers, such as auto dealers, that have less inventory on hand in 2022 may be facing this situation. Higher tax obligations could exacerbate any financial distress they’re currently experiencing.

Fortunately, the House is currently considering legislation — the Supply Chain Disruptions Relief Act — that would provide relief to auto dealers affected by LIFO liquidation. Specifically, the bill would let them wait until the end of 2025 to replace their new vehicle inventory for purposes of determining income for sales in 2020 and 2021. Stay tuned for any progress on this proposed law.

For more information

Accounting for inventory is one of the more complicated parts of U.S. Generally Accepted Accounting Principles. Fortunately, we can help evaluate the optimal reporting method for your business and discuss any concerns you may have regarding LIFO liquidation in today’s volatile marketplace.

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