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Lease Accounting for Contractors: New Rules on the Way

It’s been 13 years since the Financial Accounting Standards Board (FASB) started overhauling its lease standard. For some time now, the new rules have been scheduled to take effect for private companies with fiscal years beginning after December 15, 2019 — in other words, 2020 for companies with a calendar year end. (Public business entities are already using the new standard.) However, as of this writing, there’s strong support from various organizations, including the AICPA and AGC, for delaying the implementation date at least one year.

If your construction company is “FASB-friendly” —that is, it follows Generally Accepted Accounting Principles (GAAP) — it’s time to start preparing for the new standard if you lease real estate, equipment or other property. Because it will increase both the assets and liabilities recorded on your balance sheet, the new rules may affect the financial ratios that lenders and sureties use to evaluate your business’s financial health. (Note: The most significant impact will be on lessees; lessors won’t see major changes to their lease accounting practices.)

What’s changing?

Related Party Leases: Month-To-Month Doesn’t Necessarily Mean Short-Term
It’s not unusual for construction businesses to lease property or equipment from a related party for various tax, financial or liability reasons. Often these arrangements involve month-to-month leases or leases with terms of less than one year. But that doesn’t necessarily mean that they qualify as short-term leases that need not be recorded on the balance sheet. Under the new lease standard (see main article), one must examine factors that may indicate that such a related party lease is, in substance, a long-term lease that must be recorded.
For example, if your company has made substantial depreciable improvements to leased property, or if it would be disruptive to your business or prohibitively expensive to relocate, the lease may not qualify as short-term. The lease may also be treated as long-term if the lessee guarantees the lessor’s debt or provides the lessor with cash to pay that debt, or if the leased property is unique and not readily used by anyone other than the lessee. For further clarification and specific guidance, talk with your CPA.

Historically, leases have been classified in one of two ways:

  1. A “capital” lease, which generally involves a transfer of ownership of the underlying asset to the lessee, and
  2. An “operating” lease, which merely transfers the right to use the asset during the lease term. Capital leases are recorded on a company’s balance sheet, while operating leases aren’t (though they must be disclosed in the financial statement’s footnotes).

To improve transparency and financial statement comparability, the new standard requires most leases to be recorded on the balance sheet (with an exception for short-term leases with terms of 12 months or less). Typically, the lessee records a “right-of-use” asset that reflects the value of its right to use the leased property during the lease term, as well as a liability that reflects its obligation to make lease payments. Generally, the amount recorded, for both the asset and the liability, is the present value of minimum payments expected to be made under the lease, with certain adjustments.

The new standard retains the distinction between operating leases and capital leases (referred to as “finance leases”), but the classification mainly affects the recognition of lease-related expenses on the income statement rather than a lease’s balance sheet treatment.

Will you be viewed differently?

If your company has significant off-balance-sheet leases, it’s important to talk with your lenders and sureties about the potential impact of the new lease standard. Keep in mind that moving existing leases onto the balance sheet merely changes the way these leases are reported. It doesn’t change your company’s underlying economics, and most lenders and sureties understand this. But a sudden increase in liabilities may make your balance sheet appear weaker, so it’s a good idea to review the situation with your financial partners to be sure there are no surprises and everyone is on the same page.

In particular, you should evaluate the impact of the new standard on certain key financial ratios. In some cases, increased liabilities can cause you to violate loan covenants that are tied to debt-to-equity levels or other ratios. Although the standard contemplates the treatment of lease liabilities as “operating liabilities” rather than debt, it’s possible to fall out of compliance depending on the language of your loan agreement.

As you discuss loan covenants with your lenders, ask them to consider building some flexibility into the covenants to avoid violations triggered by future changes to accounting standards. For example, some covenants provide that, if implementation of a new accounting standard changes a financial ratio, either 1) the change won’t be deemed a violation, or 2) the parties will be required to renegotiate the covenant. In such cases, it’s important to know which avenue you’ll have to take.

Are you ready?

If your construction business is engaged in significant leasing activity, work with your CPA to review your leasing arrangements and evaluate the impact of the new lease standard on your company’s financial statements. In addition, contact your lenders and sureties before you implement the new standard to discuss potential changes to your company’s balance sheet and ensure a smooth transition.

This entry was posted on Friday, July 26th, 2019 at 3:08 pm. Both comments and pings are currently closed.