Implementing the New Leasing Standards for Contractor Financial Statements
- Michelle Landrum
Mar 13, 2023
In 2016, the Financial Accounting Standards Board (FASB) approved the new lease accounting standard (“ASC 842”) for private companies, which governs how entities record the financial impact of their lease agreements. At the time, it was determined that ASC 842 must be adopted by companies with fiscal years that began after December 15, 2021, and for interim period financial statements beginning after December 15, 2022. While the new standard was established to enhance transparency into liabilities resulting from leasing arrangements and reduce off-balance sheet activities. This change has left many organizations still grappling with the implementation.
While calculations involved in analyzing financing leases haven’t changed dramatically, the most significant impact comes from the change in accounting for operating leases. Before the new standard, operating lease rents were reported on the income statement as incurred, while future minimum lease payments were disclosed in the notes to the financial statements. With the new standard, the future annual rents for operating leases must be capitalized and reported on the balance sheet as a noncurrent right-of-use (ROU) asset with a corresponding liability for future minimum lease payments, lending itself in presentation similar to the old capital lease presentation. It also requires analyzing operating lease liabilities to categorize them as either current or noncurrent lease liabilities for presentation on the balance sheet. FASB has included a practical expedient which companies can adopt that allows short-term leases with terms of 12 months or less to forego recording the ROU asset and corresponding lease liability on the balance sheet.
Under the new lease accounting standard, Companies must classify each lease by one of the two below classification types at lease commencement:
- Finance Lease:Ownership transfers by the end of the lease term, the lease grants an option to purchase the asset that the lessee is reasonably certain to exercise, the lease term is for the major part of the remaining economic life of the asset, the present value of the lease payments and any residual value guarantee equals or exceeds substantially the fair value of the asset, or the asset is of such specialized nature that the asset will have no alternative use to the lessor at the end of the lease term.
- Operating Lease:Use of an asset is permitted, but ownership will not transfer at the end of the lease term.
The new lease accounting standard requires contractors to recognize right-of-use (ROU) assets and lease liabilities on their balance sheets for all leases regardless of the lease’s classification as a finance or operating lease. In addition, there are differences in the accounting of each type of lease on the income statement throughout the life of the lease. For finance leases, contractors will recognize interest expense on the lease liability and will amortize the ROU asset to depreciation from the commencement date to the end of the useful life of the ROU asset or the end of the lease term, whichever occurs first. For operating leases, contractors will recognize the lease expense by allocating the total lease payments evenly across the entire lease term.
Changes to Disclosures
Numerous changes were made to disclosures concerning leasing arrangements as well, with ASC 842 requiring additional disclosures that include:
- Information about the nature of leases
- Information about significant assumptions and judgments
- Segregation of the finance lease cost between the ROU assets amortization and interest on the lease liabilities
- Operating lease cost
- Short-term lease cost
- The weighted average remaining lease term for both finance leases and operating leases
- The weighted average discount rate for both finance leases and operating leases
Changes for Contractors and Their Bonding Capacity
The new lease accounting standard will most significantly impact a contractor’s financial statements, with expected changes for contractors who lease equipment or their building or office space. Because of these new financial reporting rules, many contractors may see an increased debt load, higher debt-to-equity ratios, lower working capital, and a drop in return on assets, potentially hindering future qualifications for loans and financing. These changes could further influence a company’s balance sheet and change metrics used by management and third-party lending entities.
Existing lease payments could be recorded differently under the new lease standard, potentially impacting different accounts on the income statement. Additionally, contractors’ financial ratios (e.g., debt to equity) will be most impacted, as most surety bond companies have covenants tied to these ratios. Contractors could violate these covenants under the new lease accounting rules, even if their operations have not materially changed. Surety bond companies do not like debt and may grow concerned about growing balance sheet liabilities under the new requirement.
Other items, including job costing, could be affected by the change as well, as certain lease disclosures may require companies to track lease costs, interest, and amortization expenses separately. This will require contractors to implement procedures that capture all necessary costs for leasing contract-related assets accurately to comply with the new disclosure requirements.
Have questions about how these new changes affect your business? You’re not alone. It’s important for contractors to be prepared and take the necessary measures to comply with the new leasing standards. Contact one of our construction CPAs and advisors to strategize with construction business experts who can optimize tax savings, enhance your organization’s working capital, and are ready with the information needed to ensure your business remains compliant.