Keys for Contractors to Navigate The New Lease Accounting Standard
By PHILLIP ROSS, CPA, CGMA, PARTNER
In 2016, the Financial Accounting Standards Board (FASB) finalized the new lease accounting standard (ASC 842) for private companies. After many years of pushback and delays, the time for implementation is here. The new standard must be adopted by companies with fiscal years beginning after Dec. 15, 2021 and for interim period financial statements beginning after Dec. 15, 2022.
Under previous standards, leases were broken down into two categories—financing or capital leases and operating leases. Financing lease obligations (for example—leases where the lessee took ownership of the asset at the conclusion of the lease term) were recorded on the balance sheet as a liability and the corresponding item being leased was recorded as an asset and depreciated over its useful life. Operating leases (any non-capital leases, the most common being leases for real estate, office space, yard space) were not recorded on the balance sheet at all. Rather, the lease commitment was disclosed in the footnotes to the financial statements.
Under ASC 842 this distinction in presentation is largely done away with. All leases greater than 12 months are reported on the balance sheet as a lease liability with a corresponding right of use asset, whether the lease is for real estate, field equipment, office equipment, furniture, etc. This also includes related party leases (for example, a company leases real estate which is owned by a stockholder/member). If you are a lessor, the standard has minimal impact on you.
While conceptually this may sound simple, there are several items to be considered in determining how a lease should be accounted for. The following are a few key procedures companies will have to perform to properly implement ASC 842:
- Identify and gather all of the company’s leases.
- Determine if the lease is an operating lease or a finance lease.
- Evaluate the impact on related party leases from ASC 842 and related leasehold improvements.
- Review contracts for embedded leases. For example, the company hires a subcontractor who is required to provide a specific identifiable piece of equipment which is required to stay onsite, the company can direct the usage for more than 12 months and receives substantially all the benefits of such usage.
- Identify non-lease components that could be included in lease arrangements, such as operating expenses and common area maintenance.
- Determine the discount rate to use for computation of the lease liability and right of use asset.
- Record the appropriate entries on the company’s books as the expense is presented differently for an operating lease versus a financing lease.
- Properly disclose the lease transactions in the footnotes to the financial statements. These disclosures will be significantly more extensive than the previous lease commitment footnote disclosures
Recording these leases on the balance sheet will impact the company’s covenants. A couple of examples:
- The company’s current ratio and working capital will decrease as a portion of the lease liability will be shown as a current liability and the right of use asset is a non-current asset.
- The company’s leverage ratio (debt to equity) will increase as the total debt on the balance sheet will increase while equity remains the same.
- The company’s EBITDA would improve should the company determine it has financing leases (as the expense under these leases are shown as part of interest expense and amortization expense).
Construction companies need to understand how implementing ASC 842 will affect covenant compliance with their existing loan agreements and how to account for this impact when renewing or entering into new loan agreements. Contractors will need to understand how sureties will evaluate the impact of ASC 842 in determining bonding capacity it will provide the contractor. As always, communication is key. These matters should be addressed now so there are no unpleasant surprises later when 2022 financial reports are provided to the banks and sureties.
The transition to ASC 842 will take considerable time and planning to implement. Understanding the rules and requirements for the transition can save you valuable time and reduce compliance risk.
About the author: Phillip Ross, CPA, CGMA is an Accounting and Audit Partner and Chair of the Construction Industry Group at Anchin, Block & Anchin, LLP. For more construction industry thought leadership and content, log on to www.anchin.com.