Earlier this year, the Financial Accounting Standards Board (FASB) issued a revised lease accounting standard. The new standard – Accounting Standards Update (ASU) No. 2016-02, “Leases (Topic 842)” – may impact many contractors that lease vehicles, equipment or buildings.
FASB standards apply to all contractors that must maintain financial statements that comply with generally accepted accounting principles (GAAP). GAAP-compliant statements are required by lenders and bonding companies for most privately held contractors and public contractors, as well. The new financial reporting and accounting procedures are likely to affect some of the financial ratios stipulated in various types of loan covenants and surety agreements. Now is a good time to proactively plan in order to try to pre-empt potential problems.
Under existing accounting rules, operating leases generally do not appear on a company’s balance sheet. This applies to all types of operating leases, including leases for vehicles, equipment, office machines, and office or warehouse space.
Under the new standard, you will be required to record the present value of the scheduled lease payments as a liability on the balance sheet. This liability would be balanced by recording the “right-of-use” value of the property or equipment as an asset. (There could be minor additional adjustments to the asset to reflect broker’s fees or other direct costs.)
The new standard allows an exception for short-term leases or those lasting less than 12 months that do not include a renewal option the lessee is “reasonably certain” to exercise. This means even short-term leases must appear on the balance sheet if they include extension options that meet these criteria.
The most significant effect of the new lease accounting rules for most contractors will be their impact on commonly used financial metrics, particularly the working capital ratio and the debt-to-equity ratio. Many loan agreements and surety contracts require contractors to maintain these ratios at specified levels and to submit financial statements that demonstrate compliance. As a result, many contractors could find themselves out of compliance because of lease obligations that drive up their current liabilities and total liabilities.
Operating Leases v. Finance Leases
The existing standard makes a distinction between operating leases and capital leases, such as those that offer a bargain purchase option at the end of the lease. Because capital leases are generally regarded as a form of financing, they are already recorded on the balance sheet as a liability.
Under the new standard, this distinction is less important, since all leases over 12 months in duration will now appear on the balance sheet. The interest and amortization expenses for the two types of leases are handled differently, but these distinctions will not affect most contractors significantly. The new standard also changes the terminology somewhat, referring to finance leases instead of capital leases.
Other Related Matters
Many leases in the construction industry involve company owners who purchase property and lease it back to their businesses. The new lease accounting rules apply to such related party leases the same as third party leases, based on the “legally enforceable” terms of the lease agreement.
How to Prepare
For publicly traded companies, the new lease accounting standard will take effect for reporting periods beginning after Dec. 15, 2018. For privately held companies, the new standard goes into effect for reporting periods beginning after Dec. 15, 2019. Companies can begin applying the standard sooner if they choose.
Although the effective date seems to be far in the future, implementation of this standard will generally be overlapping with the implementation of FASB’s new revenue recognition standard. Because of this, companies should begin responding to this new standard sooner rather than later through the following methodology:
1. Understand the new standard and monitor changes in interpretation that are naturally expected to occur.
2. Create a cross-functional implementation team (e.g. finance, legal, operations, human resources, I.T.) and plan to implement the new standard.
3. Identify and communicate with stakeholders regarding the potential impacts to financial metrics, covenants, and other agreements (e.g. compensation).
4. Populate lease data and establish required judgments, estimates and accounting policy elections.
How HBK Can Help
HBK’s multidisciplinary team of accounting, tax and valuation professionals are available to assist in assessing how the new leases standard will impact you. Existing attest clients will receive training services on the technical aspects of the new standard as well as advice on project management and planning. Further assessment and implementation services are available to non-attest clients.