Now that the U.S. Financial Accounting Standards Board (FASB) has finalized new lease accounting standards effective Dec. 15, 2018, for public companies and Dec. 15, 2019, for private companies, construction companies can finally move forward and prepare for adoption.
The lease accounting standard is the rule that pertains to the financial accounting and reporting of lease contracts. The standard was changed to provide decision-useful information to investors and other users of financial reports, and to respond to a Securities and Exchange Commission (SEC) directive to bring assets and liabilities on the balance sheet.
Changes in Operating Leases Accounting
A major change is how operating leases are accounted for on corporate balance sheets. Instead of appearing as a table of future payments in the footnotes, they will appear on the balance sheet as a non-debt liability. The new rules have no impact on the income statement and there is a limited effect on debt covenants. The rules for classifying whether a new contract is a capital (finance) or an operating lease are virtually the same as before under generally accepted accounting principles (GAAP).
The capitalized asset cost with operating leases will be lower compared to a loan or cash purchase, so it is still important that the lease be an operating lease even though it is capitalized. An operating lease’s capital asset cost is lower than a lease or cash purchase because the balance sheet presentation of an operating lease reflects only the present value of the rents due under the contract as the asset amount. As a result, it is still “partially” off-balance sheet. Because the cost of an operating lease is reported as a straight line expense of the full lease payment each period, there is no front-end loaded P&L impact that comes from expensing depreciation and imputed interest costs as there is when borrowing to make an outright asset purchase. The net result is that leasing, compared to borrowing to buy, will show a better ROA, which can be the basis for bonus compensation and ROA is a measure used by equity analysts.
Impacts on Construction Businesses
What do the lease accounting changes mean for contractors?
- A credit rating should not change. Bank lenders and credit analysts already take into consideration the operating lease obligation included in the footnotes. They estimate the value of the implied asset and liability created by operating leases to adjust their measures and ratios used to make credit assessments. The proposed formula to capitalize operating leases under the new rules is substantially the same as the method used by rating agencies today.
- The new rules will be implemented retroactively, so all operating leases (except for short-term leases) will need to be capitalized in the financials reported in the transition year. If comparative balance sheets and P&L statements are presented the operating leases must be capitalized in the earliest balance sheet. This means the impact may be sooner than later.
- Whether all leases on the balance sheets need to be recognized depends on the lease terms and conditions. If reporting under International Financial Reporting Standards (IFRS)/U.S. GAAP, the answer is yes. However, if the contract duration is equal to or less than 12 months, the off-balance-sheet approach previously used for operating leases applies. If the contract qualifies as a service, the contract does not have to be recognized on the balance sheet. For IFRS companies, the lease does not have to be recognized if the value of the asset is low (with a benchmark less than $5,000), irrespective of term. (NOTE: This is not the case under U.S. GAAP.)
Preparing for the New Standard
There are five basic areas to address to make the lease accounting changes go smoothly.
- Inventory all equipment lease and rental contracts. Know the amounts and nature of contractual obligations and terms of leases in order to understand the company’s accounting and tracking needs.
- Identify IT/software requirements. To determine if the technology in place will meet the new standards, find out how accounting software supports the changes.
- Review debt covenants. Although the lease accounting changes will have limited effect on debt covenants, discuss fully any implications with the company’s banker or creditors.
- Seek out industry expertise and counsel. In addition to accounting expertise, consult with the equipment finance provider. Providers have hands-on experience, informational resources and advice on industry best practices to help assess the possible impact of the changes on current and future leasing needs.
- Enact a plan. Start planning the budget and resources necessary for updates and systems changes to support the new rules.
Leverage Opportunities from Change
Reexamining and assessing business processes to accommodate the lease accounting changes could reap unexpected advantages. Better information and controls can help enable better tracking and asset management, avoid redundancies and allow negotiation of better lease terms throughout the organization.
Disclaimer: The information in this document is a summary only and does not constitute financial advice. Readers should obtain their own independent accounting advice that takes into account all relevant aspects of a particular lessor’s or lessee’s business and products.