April 20th, 2017 Anticipate Effects of FASB Lease Accounting Standard This past January we discussed how new lease accounting rules may affect contractors. We wanted to revisit that topic to continue the discussion about why it’s important to prepare early, even though the deadline for implementation is still several years away. The Financial Accounting Standards Board’s (FASB) new lease accounting standard could have a significant effect on some commonly used financial metrics that are closely watched by lenders and bonding agents. Contractors should consider taking several important steps well in advance of the deadline. Changing Standards – Why It Matters One of the most significant effects of Accounting Standards Update (ASU) No. 2016-02, Leases (Topic 842) is its potential effect on several key ratios – particularly the working capital and debt-to-equity ratios. Lenders and sureties typically require you to maintain these ratios at specified levels and to regularly submit financial statements that demonstrate compliance. The potential problem stems from the fact that, under the new standard, all long-term leases will now be reflected on the balance sheet. This applies to all types of operating leases including leases for vehicles, equipment, office machines and office or warehouse space. Under ASU 2016-02 you will be required to record the present value of scheduled lease payments for operating leases of more than 12 months’ duration as a liability on the balance sheet. This liability will be offset by recording the “right-of-use” value of the property or equipment as an asset so the overall statement stays in balance. Nevertheless, the changes will have an unequal effect on individual line items. As a result, your company could find itself out of compliance with required covenants — simply because the rules changed. The Early Effects For publicly traded companies, the new lease accounting standard will take effect for reporting periods beginning after Dec. 15, 2018. For privately held companies, the new standard goes into effect for reporting periods beginning after Dec. 15, 2019. These dates are one year later than the comparable dates for the new revenue recognition standard. So it might be tempting to focus on revenue recognition first and set aside the lease accounting changes for now. In fact, though, now is the time to start focusing on the new lease accounting standard as well. This is especially true if you are initiating or extending a loan or credit line that will still be open after the implementation deadline, or undertaking a multiyear project that will require bonding past 2019. Three Alternatives Some large lenders and bonding agents are already adapting their contracts to reflect the coming changes. In other cases, though, it could be necessary for you to initiate the effort. If so, you and your lender or surety will probably choose one of three approaches: Incorporate a “frozen GAAP” contract provision. This says that regardless of future changes in GAAP, future required financial ratios will continue to be calculated according to the GAAP rules that were in effect at the time the contract was executed. Incorporate a contract provision that accommodates a transition to the new standard, but specifically excludes operating lease assets and operating lease liabilities when calculating key ratios for compliance. Recalculate what the key ratios would be if the new standard were already in effect and use this calculation to establish new benchmarks. There are pros and cons to each of these options, so it’s important to discuss your concerns openly at the outset of any new credit or bonding agreement. The ultimate objective is to ensure there will be consistent rules and expectations throughout the duration of the contract. For more information on Sansiveri’s Construction and Related Services Group and how we can assist your company, please contact Jason DaPonte, CPA, CCIFP, CIT, Partner, at 401-752-0558.