Most contractors know they must comply with the new lease accounting standard (ASU No. 2016-02, Leases. Topic 842) issued by the Financial Accounting Standards Board in February 2016. It was adopted to address the concerns of sureties, bankers, investors and other users of financial statements on lease obligations.
A benefit of the ASU is that users of financial statements will have more transparent and comparable information on lease obligations. Sureties will have more accurate information on which to base a bonding decision.
These standards are effective for fiscal years beginning after Dec. 15, 2018, including interim periods in those fiscal years, for any of the following:
- A public business entity;
- A not-for-profit entity that has issued, or is a conduit bond obligor for, securities that are traded, listed or quoted on an exchange or an over-the-counter market; and
- An employee benefit plan that files financial statements with the U.S. Securities and Exchange Commission.
For all other entities, the new lease accounting standards are effective for fiscal years beginning after Dec. 15, 2019, and interim periods within fiscal years beginning after Dec. 15, 2020. Early application of the standards is permitted for all entities.
Generally, all entities that lease assets (lessees) such as real estate, equipment or vehicles must be in compliance with the ASU. It requires that capital (finance) and operating leases are recognized on the balance sheet. The right-of-use value of property or equipment must be recorded as an asset and the present value of scheduled lease payments as a liability. Right-of-use assets include initial direct costs (such as legal fees, advanced payments and lease incentives).
The ASU applies to related party leases based on the legally enforceable terms of the agreement. Short-term leases of 12 months or less that do not include an option to renew may be exempt.
The ASU will have little impact on the accounting requirements of the entity that owns the assets being leased (lessor). It will provide users of financial statements with additional information on a lessor’s leasing activities and the related assets and exposure to credit risks.
Contractors should be aware of how the ASU will impact the following.
- Balance Sheet: Lease obligations generally increase assets and liabilities. Higher liabilities may make it difficult to obtain bonding.
- Financial Ratios: A contractor’s working capital ratio and debt-to-equity ratio may be pushed above the acceptable threshold. The contractor may no longer be in compliance with bond agreements or covenants.
- Expense Recognition: Capital leases typically result in accelerated expense recognition for financial statement purposes under the ASU. Operating leases have a constant annual cost. The right-of-use cost can generally be amortized over the lease term on a straight-line basis. The lease liability is based on an effective interest rate calculation.
- Sale and Leaseback Transactions: Real estate transactions may qualify for sale and leaseback accounting. Contractors should take this into account when contemplating tax planning strategies as a source of taxable income to support future deferred tax assets.
- Taxable Income and Deductions: Contractors may have to recognize deferred assets and deferred liabilities in reporting excess on right-of-use assets and the related lease liabilities according to generally accepted accounting principles.
- Valuation Allowance: Changes recorded in deferred tax assets and liabilities, as well as how book-to-tax differences are reversed under the ASU. A contractor’s valuation allowance and net operating loss carryforwards can be impacted.
There are many other factors contractors must consider regarding the ASU, such as the tax implications of leverage leases; state sales and use taxes, franchise, net worth and other non- income-based taxes; and interest expense, personal property or real estate taxes and transfer pricing.
Contractors should consult with a construction accountant to discuss how changing accounting methods, tax planning and complying with the ASU will impact current and future surety agreements and debt covenants.
