The past 18 months have been a tumultuous time for the construction industry. Construction companies are facing the unprecedented challenge of navigating operations through a global pandemic that created difficult work conditions, labor shortages, rising material prices, supply chain interruptions, and several other difficulties. If that wasn’t enough, the time to implement the long-awaited new lease standard has arrived. Accounting Standards Update (ASU) 2016-02, Leases (Topic 842) will go into effect for private companies with fiscal years that start after December 15, 2021, therefore, calendar year companies must implement the lease standard on January 1, 2022.
Most industries will be significantly impacted by this new standard and the construction industry is no exception. Typically, construction companies have leased property of similar complexion, such as office buildings, office equipment, vehicles, and construction equipment. The new standard generally applies to long-term leases as opposed to short-term leases (i.e., lease terms of less than 12 months at lease commencement). Companies should anticipate spending time to fully understand the new standard and determining how it will impact them in regard to internal operations, financial reporting, and business decisions.
Under the old standard (ASC 840), the items noted above would be categorized as capital or operating leases. Capital leases have characteristics of asset ownership and would be recorded on the balance sheet. Alternatively, operating leases do not carry ownership rights to an asset and are recognized as an operating expense on the income statement.
Under the new standard (ASC 842), capital leases are now called finance leases and the name operating leases is unchanged. Operating and finance leases will be presented in a similar fashion on a company’s balance sheet as both types of leases are initially measured at the present value of the lease payments and a right-of-use asset and lease liability are now recorded. However, the operating right-of-use asset cannot be shown in the same line as the finance right-of-use asset, and the operating lease liability cannot be shown in the same line as the finance lease liability.
The differences between operating and finance leases in financial reporting lie primarily within the statement of income and the statement of cash flows.
On the statement of income, interest on the lease liability is shown separately from the amortization of the right-of-use asset for finance leases. Operating leases show a single lease cost which is calculated based on a straight-line allocation of the cost of the lease over the length of the lease.
On the statement of cash flow, repayments of the principal portion of the finance lease liability are shown within financing activities. Payment of interest on the lease liability is shown within operating activities for finance leases. For operating leases, all repayments of the lease liability are shown within the operating activities.
How the New Standard Will Affect You
As illustrated above, the new lease standard will have a significant impact on financial statement presentation. These additions will dilute your financial ratios and reduce the strength of your balance sheet. This may cause concern among the users of your financial statements. Some examples are as follows:
- Lenders/Banks – the new standard may cause you to fail certain financial covenants or lead to a reduction in lending from financial institutions.
- Sureties – the new standard may cause sureties to reduce your bonding capacity thus having a significant negative impact on your operations.
- Investors/Stakeholders – historical financial ratios traditionally used to evaluate the health of your company may be interrupted.
- Your Employees – Additional strain may be placed on your employees as they work on implementing the new standard and develop ways to evaluate, track, and record leases.
How Can You Prepare?
While the overall concept of the new lease standard seems simple, there are many nuances companies will need to familiarize themselves with during the implementation process and beyond, such as:
- Policy elections and practical expedients
- Criteria for identifying leases embedded in service or supply agreements
- Calculating the right-of-use asset and lease liability
- Combining or separating lease and non-lease components
- Related-party/rental leases
- Educate yourself - You should begin by educating yourself and your team on the new lease standard. Brainstorm and discuss how the standard will impact your company.
- Gather your lease agreements and amendments as well as any service or other contracts that could contain leases. These will range from rental agreements, to equipment leases, and should include leases from related parties, too.
- Evaluation of existing leases - Once you have compiled this information, you will have to evaluate how many leases fall under the new standard. From here, you may want to consider reaching out to your external accountants or researching software solutions for assistance in the evaluation of leases, the calculation of the right-of-use assets and lease liability, and how to track the leases.
- Reach out to users of financial statements - Either concurrently or after you have evaluated the impact of the new lease standard on your company, begin communication with lenders and sureties to discuss how the new standard will impact the financial statements.
- If you are able to communicate and demonstrate that the new standard is the reason for a potential failed covenant, this communication may lead to an important modification of the lending agreement. Furthermore, you want to be organized and proactive in communication with your surety to ensure they are educated on the new standard and understand its impact when evaluating your financial statements.
The new lease standard will have a significant impact on the financial reporting aspect of your business. However, with proper planning and education on the standard, any potential pitfalls can be mitigated or avoided completely. Please reach out to your accounting professional to discuss the impact on your business prior to implementation.
This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.