Financial Reporting: How New Lease Accounting Rules Will Affect Contractors

By Carol Wagner, Principal
ASL Construction Group

Earlier this year, the Financial Accounting Standards Board (FASB) issued its long-awaited revised lease accounting standard. The new standard – Accounting Standards Update (ASU) No. 2016-02, “Leases (Topic 842)” – could have a significant impact on 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). While this includes publicly traded companies, GAAP-compliant statements are also required by lenders and bonding companies for most privately held contractors.

The significance of the revised standard extends beyond financial reporting practices alone, however. The new accounting procedures are likely to change some of the required financial ratios that are spelled out in many loan covenants and surety agreements. Therefore, contractors should start preparing for them now in order to head off possible problems down the road.

What’s Changing

Under existing accounting rules, operating leases generally do not appear on a company’s balance sheet. For example, if you enter into a five-year lease on a piece of equipment with a 10-year useful life span, the monthly lease payments appear on your income and expense statements, but there is no balance sheet entry reflecting the lease. 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-to-use” value of the property or equipment as an asset. The new standard allows an exception for short-term leases. These are generally defined as leases of 12 months or less that do not include a “legally enforceable” renewal option the lessee is likely to exercise. This means even short-term leases must appear on the balance sheet if they include extension options that don’t meet this criterion.

How Contractors Will Be Affected

The most significant effect of the new lease accounting rules for most contractors will be their impact on commonly used financial metrics, particularly the debt-to-equity ratio. Many loan agreements and surety contracts require contractors to maintain this ratio at a specified level 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 balance sheet liabilities. Other less commonly used metrics could also be affected.

Operating Leases and 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 defining operating leases slightly different than our current definition and creating the new term of finance leases. Regardless of the terminology, the takeaway is the majority of leases will be recorded on the balance sheet.

In the case of related party leases, company owners who purchase property and lease it back to their businesses will find that lessor accounting practices are basically unchanged under the new standard.

How to Prepare

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 mandatory implementation is still several years away, it’s important to start planning for the transition right away. Begin with a thorough inventory of all your company’s lease contracts. Once all leases are identified, we will work with you to determine how the new standard will affect your financial statements. As you enter into new lease agreements, factor in how these will be reported on your financial statements. And finally, begin the conversations with lenders and sureties about how certain key ratios will change. Getting an early start in preparations will also make it easier to adjust covenant requirements or other contract terms as necessary.