Right on the heels of changes in revenue recognition that sureties will, for the most part, begin to see on financial statements for the years ending Dec. 31, 2019, comes another significant change to nonpublic contractor financial statements. This change is the new accounting standard on leases, which is effective for nonpublic companies for fiscal years beginning after Dec. 15, 2019 (for practical purposes that means a Dec. 31, 2020, yearend).
The Financial Accounting Standards Board (FASB) voted on July 17, 2019, to propose delaying the effective date for nonpublic companies by one year, until fiscal years beginning after Dec. 15, 2020; however, the proposal must go through public comment before a determination on whether the delay will go into effect. The changes required by this new standard will impact traditional financial analysis of contractors, affecting the income statement and balance sheet presentation, working capital and debt/equity ratios, and are also expected to create challenges to loan debt covenants. Interim 2020 financials issued for nonpublic companies are not required to use the new standard.
The latest presentation, though required at a minimum to be computed as of the first day of the 2020 fiscal year, will more likely show up for the first time on the contractor’s 2020 annual financial statements.
The new standard, technically referred to as ASC 842, is already in effect for public companies for their fiscal years beginning after Dec. 15, 2018. Although early adoption of this standard was allowed, only two public companies chose to do so—Microsoft and Target—which is an indication of the complexity of the new rules. Accountants are starting to see presentation and disclosures on the new standard for public company interim financial statements as of their March 31, 2019, quarterly reporting.
Financing Leases and Operating Leases
The new standard calls for changes for both financing leases (formerly called capital lease obligations) and operating leases. While calculations involved in analyzing financing leases haven’t changed dramatically, the bigger impact will come from the change in accounting for operating leases. Prior to the new standard, operating lease rents were reported on the income statement, and future minimum lease payments were disclosed in the financial statement. However, the new standard requires the annual rents for operating leases to be capitalized and reported on the balance sheet as an asset with a corresponding liability for the future minimum lease payments.
The new standard requires that operating leases be analyzed to break them down into noncurrent lease assets and current and noncurrent liabilities for presentation on the balance sheet.
The technical discussion starts with an analysis of the old standard (and is still the standard for 2019 nonpublic financial statements). The old rules (now codified as ASC 840) were issued in November 1976. Leases were classified into two categories: capital leases and operating leases.
If the transaction met one of four rules (see box at left) it was deemed a capital lease. Rather than lease payments being reflected as rent expense in the income statement, the present value of the lease payment stream was capitalized as an asset recorded in the noncurrent asset section of the balance sheet, and a corresponding liability “capital lease obligation” similar to a note payable was recorded.
As lease payments were made during the year, a portion of the payment would be applied to the underlying obligation and a portion treated as interest expense. The asset was amortized over its economic life.
All other leases were treated as operating leases, with the lease payment recorded as rent expense in the income statement.
Under the new rules (ASC 842) issued in 2016, the terminology changes from capital lease to a finance lease (see five qualifications in box below).
The main changes have to do with “majority” rather than “75%” of the economic life, and present value equaling or exceeding the fair value of the asset as opposed to “90%” of the fair value. Recording and accounting treatment of the asset and liability for a finance lease is the same as for the prior capital lease. If a lease doesn’t meet the finance lease rules, it is also called and treated as an operating lease, but there are changes to the accounting and presentation.
For an operating lease, a “right of use asset” and a “lease liability” must now be recognized. The lease liability is calculated as the sum of the present value of the rest of the lease payments, using a discount rate. Nonpublic companies can elect an accounting policy to use a “risk-free” discount rate at the date of commencement of the lease. That will usually be the U.S. Treasury yield rate for a similar lease length.
Lease Payment Calculations
The contractor has the option to perform and record the calculation as of the first day of its current year and to present comparative information under the prior method. In the alternative, it may go back and recalculate as of the first day of the comparative year, presenting both years under the new standard. In either case, calculations on previously existing leases will require recording the resulting change to equity as a prior period adjustment. Most contractors likely will elect to perform the calculation as of the first day of their 2020 fiscal year.
Lease payments include fixed payments, any variable payments tied to an index, the exercise price for a purchase option that is reasonably certain to be exercised, and penalties for terminating the lease if the lessee is reasonably certain to terminate a lease. If the lease is considered to be short-term (12 months or less as of the commencement date), the lessee can elect not to recognize a “right of use asset” and corresponding “lease liability,” and may treat all lease payments as expenses. All operating leases with related parties, such as leasing of land, buildings and equipment, will fall under the standard. The impact on a balance sheet will be to record a noncurrent asset accompanied by both a current liability and a noncurrent liability, impacting working capital and debt-to-equity ratios. The income statement will not see major impacts.
Impact on Bonding Decisions
How will these changes impact bonding decisions, especially when factored for potentially multiple leases? For example, a contractor may find itself in violation of debt covenants on its loan agreements. A violation of a debt covenant causes the corresponding debt to be classified as current unless the lender provides a waiver.
One more complication exists for contractors. The treatment for income tax purposes has not changed, creating additional financial statement to income tax return differences, resulting in additional deferred tax assets and liabilities.
What should contractors be doing in 2019 to prepare for the new lease standard? They should be undergoing a detailed analysis of all leases to determine the impact on their financial statements. They should be comparing changes in ratios to their existing debt covenants, engaging in a discussion with their bankers and possibly renegotiating loans. They should be examining the terms of all of their lease agreements, including those with related parties.
If, for example, they decide to change a related party operating lease for a building to 12 months or less, they will have to analyze the impact of any leasehold improvements to that building they may have recorded on the books. What is the economic life of a leasehold improvement if the lease is 12 months or less? Will the remaining balance need to be amortized in the year of change?
The contractor will also have to make the decision whether to apply the new standard retroactively to the first day of a comparative fiscal year or to apply the new standard only to the first day of its 2020 fiscal year. Hopefully, the contractor will be working with a CPA firm well-versed in construction financial and tax return matters to help the firm navigate the new lease standard.
This article is an excerpt from the article originally published in the Fall 2019 issue of the NASBP magazine, Surety Bond Quarterly. For more information, visit www.suretybondquarterly.org.
