January 23rd, 2017 How New Lease Accounting Rules May Affect Contractors 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 new financial reporting and accounting procedures are likely to affect some of the 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 a five-year lease on a piece of equipment with a 10-year useful life, 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-of-use” value of the property or equipment as an asset. (There could be minor additional adjustments to the asset to reflect broker’s fees or other direct costs.) The new standard allows an exception for short-term leases. These are generally defined as leases lasting less than 12 months that do not include a renewal option the lessee is “reasonably certain” to exercise. This means even short-term leases must appear on the balance sheet if they include extension options that meet these criteria. 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 working capital ratio and the debt-to-equity ratio. Many loan agreements and surety contracts require contractors to maintain these ratios at specified levels 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 current liabilities and total 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 somewhat, referring to finance leases instead of capital leases. Related Party Leases Many leases in the construction industry involve company owners who purchase property and lease it back to their businesses. The new lease accounting rules apply to such related party leases the same as third party leases, based on the “legally enforceable” terms of the lease agreement. How to Prepare 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. 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. Keep in mind that sometimes leases are embedded in service contracts or provided alongside other goods and services. Therefore, identifying all the affected contracts could take some diligence. Once all leases are identified, work with your accountant to determine how the new standard will affect your financial statements. Then talk to 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. Implementation of new accounting standards can be a relatively simple process with the help of a CPA with an expertise in your industry. 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.