Does your company lease any of its vehicles or equipment? If so, and you follow U.S Generally Accepted Accounting Principles (GAAP) to prepare your financial statements, some important changes are about to go into effect.
In February 2016, the Financial Accounting Standards Board (FASB) issued its long-awaited update revising the treatment of leases on your financial statements: Accounting Standards Update (ASU) 2016-02 Leases (Topic 842).
If you own a business, then you have likely heard the buzz around the new lease accounting standard and the significant impact it will have on the way you record leases. For construction and other lease-heavy industries, we can expect to see major changes in not only balance sheets, but how investors, sureties and lenders use this pertinent information to assess businesses.
In fast-paced industries like construction, analyzing accounting standards and tracking leases understandably falls low on the day-to-day priority list. However, proactive planning will be key to successfully implementing the new lease standard while ensuring your bonding and financial lending remains unaffected.
Under existing GAAP rules, leased business assets are accounted for in two different ways, depending on the classification of the lease in question. Companies have historically classified leases as either operating leases or capital leases. Capital leases were recorded if the lease was for most of the expected useful life of the asset. The company would recognize capital leases as assets and liabilities on their balance sheet. Meanwhile, leases that did not meet the definition of a capital lease were considered operating leases. The accounting treatment for operating leases was to expense the payment as rent expenses and disclosure in the footnotes.
Under the new standard, businesses must now disclose on their balance sheets assets and liabilities all leases of more than 12 months. You can no longer separate the two classifications.
Going forward, your company will have to report a right-to-use asset and a corresponding liability for the obligation to pay rent. You will get to discount the asset to its present value using either a rate implicit in the lease or your incremental borrowing rate.
The old classifications remain relevant, however. They will determine the recognition, measurement and presentation of expenses and cash flows arising from a lease.
Specifically, for capital leases, lessees must amortize right-to-use assets separately from interest on the lease liability on the statement of income. On your statement of cash flows, you will classify repayments of the principal portion of the lease liability within the financing activities section of the statement. Meanwhile, you will denote payments of interest on the lease liability and variable lease payments within the operating activities section of the statement.
When it comes to operating leases, lessees need to recognize a single total lease cost, calculated so that the cost is allocated over the term on a generally straight-line basis. On your statement of cash flows, you will reclassify cash payments within the operating activities section.
The new standard will add other required disclosures to aid users in understanding your construction company’s financial statements as well. For example, you will need to disclose qualitative and quantitative requirements – such as details of variable lease payments and options to renew and terminate leases.
Where to Start
Lease-heavy industries should start collecting their lease documents as soon as possible. For construction companies, leases can include everything from equipment, trucks, storage and yard space and office facilities. All of these leases will need to be collected, have their terms identified and values recorded on the balance sheet. For leases not previously recorded on the balance sheet, the values must be recorded as a right-to-use asset at their present value of lease payments. While this will generally not result in a significant change to your net equity, it does have the potential to significantly affect two key areas that rely on the financial statements.
One of the most critical components of the financial statements is working capital (current assets minus current liabilities), as this shows the contractor’s ability to service upcoming obligations. Working capital is also a major factor in your bonding capacity.
Under the new leasing standard, working capital will decrease, as the next twelve months’ worth of lease payments will be added to current liabilities, while the leased asset will be noncurrent.
If you have bank loans that require you to maintain certain financial ratios, these could be negatively impacted by the new lease standard. For example, a maximum debt to equity ratio could pass under the current rule, but fail after the leases are added to the balance sheet as liabilities.
As the time to implement these new rules gets closer, you should contact your CPA to see how they will affect your balance sheet, your bonding agent on how this will affect your capacity and your banker to make any necessary adjustments to your agreements so any ratios or covenants do not become unreasonable under the new standard.
Nonpublic businesses that follow GAAP don’t need to comply until annual and fiscal years beginning after December 15, 2019, and for interim periods beginning a year later. You may, however, adopt the new standards provisions earlier. Suttle & Stalnaker’s construction accountants can help you incorporate these changes into your construction company’s accounting practices.