Changes to the way your construction company accounts for leases are on the horizon. Are you ready?
The use of leases in the business world is widespread. Businesses can lease land, buildings, rail cars, airplanes, large machinery, office equipment … the list goes on and on. Chances are, your business uses leases in some way.
The reasons businesses use leases vary, but the bottom line is that all leases have to be accounted for in financial statements.
Why the Need for the New Rules?
The current accounting standards governing leases have long been a topic of discussion by financial statement users.
Many users criticize the rules for not requiring enough information about a company’s leasing transactions in financial statements. Also, the application of current standards results in various interpretations of the rules and how businesses classify and present leases in their annual reports. It is often difficult to determine the true financial impact of a company’s leasing activity.
In response to the issues raised about accounting for leases, the Financial Accounting Standards Board (FASB), the rule-setting body for accounting standards, sought to identify the problems with the current rules and develop new guidelines for improved lease reporting.
The result was a new accounting standard, issued in February 2016, which covers both lessees and lessors.
Who Do the New Rules Apply To?
While the accounting rules for lessors will remain generally unchanged, the rules for lessees will change significantly.
If your business currently leases property or equipment, then your financial statements could be significantly impacted by the upcoming changes in the accounting standards.
The Nitty Gritty of the New Lease Accounting Rules
Under current lease rules the accounting treatment of a lease may be different depending on how the lease is structured. Business owners are probably familiar with the terms “capital lease” and “operating lease.”
If the terms of the lease basically transfer ownership of the property to the lessee by the end of the lease term, or if the lease term is approximately equal to the economic life of the asset, the lease is known as a capital lease, and the value of the leased asset, along with the related lease obligation, are shown on a company’s financial statements. The asset is then depreciated similar to other assets owned by the entity.
Generally, if the lease is not a capital lease, then it is classified as an operating lease. Payments under operating leases are usually expensed as incurred, with little or no impact on a company’s balance sheet, but are normally included in the notes section, sometimes referred to as disclosures, of the financial statements. Additionally, leases with a lease term of less than 12 months do not fall under the current lease rules.
What’s a Contractor to Do to Comply with the New Rules?
The new lease standard brings with it many changes, from accounting requirements to terminology.
Most importantly, lessees will be required to recognize lease assets and related lease liabilities on their balance sheet, regardless of the type of lease. Recording of both financing leases (the old capital lease) and operating leases will result in the recording of a “right-of-use” asset and a lease liability that will be measured at the present value of the lease payments called for under the lease.
On a company’s income statement, the payments on a financing lease will be reflected as depreciation of the right-of-use asset, and interest expense on the lease liability, while an operating lease will be reflected as a single lease expense.
The new rules also require expanded note disclosures in the financial statements. For leases with terms of less than 12 months, the business can elect not to report lease assets and liabilities.
Consideration should be given to the new definition of a lease, which is now defined as a contract, or part of a contract, that conveys the right to control the use of identified property, plant or equipment for a period of time in exchange for consideration. Right to control is generally defined as the lessee’s right to the economic benefit from the use of the asset, and the right to direct the use of the asset. An identified asset is defined as being explicitly specified in a contract or implicitly specified at the time of the initiation of the lease term. Contractors might find that some of their current leases no longer meet the new definition of a lease.
Upon adoption of the new standard, you will need to use a “modified retrospective approach” where your business is required to apply the new standard and reporting to all of its current leases and any future leases.
There are several elections that can be made and reliefs available in the standard relative to initial adoption, and you should be aware of your options in the period of transition to the new rules.
What Is the Deadline for Adopting the New Rules In Your Financial Statements?
The new lease rules will impact your business through the use of something called the “effective date" – the date by which your business MUST adopt the new standards and present leases in financial statements under the new rules.
For non-public companies, which covers most small businesses, the effective date is for the year starting after December 15, 2019. For most construction companies, it’s the 2020 calendar year.
Keep in mind that the new standard will be required for all years presented in your company’s financial statement. Therefore, as many contractors present multiple years in their statements, any prior periods presented must reflect leases under the new rules.
Why Should You Start Thinking About the New Rules NOW?
At first glance you might dismiss the impact of the new standard, at least for now. After all, it’s still a few years away. However, NOW is the time to start thinking about how the new rules will affect your business.
Upon adoption of the new rules, you might find that you suddenly have additional assets and liabilities on the books that were not there before. Additional liabilities can directly impact ratios and other financial covenants for banking and bonding purposes.
Keep in mind that some of the new leases that your company enters into in the next few years will be impacted when adopting the new rules. As an owner or financial officer of your business, you need to be aware of these changes in order to plan for the future and eliminate the surprises this new standard might bring.
Contractors can proactively plan for implementing the new standard by charging someone in the business with learning the new rules and requirements, identifying all of the leases your business has, and evaluating those leases for conformity with the new standard.
Once the leases are identified, you can calculate the effect on your company’s financial reporting, and develop a strategy for adopting the new standard.
Now is the time to plan for the changes. Our Construction Group can help you sort through the changes and determine exactly how your company needs to prepare. Contact us here or call 800.899.4623.