How the Construction Industry Can Prepare for the New Lease Guidance
New guidance on lease recognition has been released by the Financial Accounting Standards Board in ASU 2016-02. The guidance will affect privately-held companies with fiscal years beginning after December 15, 2020. Construction contractors will be impacted, specifically those with a large fleet of leased vehicles. Now is the time to start preparing for the new requirements and adjust the balance sheet before they go into effect.
Under the current guidance, lessees do not record an asset or liability on the balance sheet for items under operating leases. Instead, rent expense is recorded when payments are due. Some argued that this treatment did not give users of the financial statements a clear representation of the company’s financial position. As a result, the new guidance uses the “right-of-use” model.
This new lease guidance requires lessees to recognize a right-of-use asset and a lease liability on the balance sheet for leases previously classified as operating leases. This is similar to the current treatment of capital leases. There has been a lot of speculation in the last couple of years regarding how ASU 2016-02 will affect accounting for construction contractors. Contractors with a large fleet of leased vehicles are likely to be significantly affected by the new lease standard, especially if they have to meet certain debt covenants.
The “right-of-use” model adopted reflects that a lessee has an obligation to make payments to the lessor, but at the same time has the right to use the asset over the length of the lease term, thus the need to record an asset and a liability.
Steps to Take to Determine Recognition Under the New Guidance
First, the entity should classify their leases as either capital or operating. Capital lease classification, called “finance lease” under the new guidance, rules have changed under the newly created Accounting Standards Codification (ASC) 842. Specific criteria are outlined in ASC 842. If the lease meets any of the four following criteria, it is considered a finance lease if:
- The lease term is for a major part of the remaining economic life of the asset
- The present value of the sum of the future minimum lease payments exceeds “substantially all” of the fair value of the asset
- The lease transfers ownership to the lessee at the end of the lease term
- The lease has an option for the lessee to purchase the asset that the lessee is reasonably certain to exercise
- The asset is specialized to the extent that it is only useful to the lessee
For all operating leases, the company should determine whether the lease is considered a long-term lease or a short-term lease.
- Generally, a lease is considered short-term if its length is less than or equal to 12 months and there is no option for the lessee to purchase the asset at the end of the lease term.
- If the lease is deemed a short-term lease, the lessee may recognize payments over the lease term on a straight-line basis without having to include it on the balance sheet.
- If the operating lease is considered long-term, the company will need to measure the right-of-use asset. This is generally calculated as the present value of future lease payments, including variable payments. The asset and liability should be presented as separate line items on the balance sheet or disclosed in the notes to the financial statements.
Other Impacts Beyond the Balance Sheet
In addition to the balance sheet impact of the new guidance, construction companies should consider the potential impact on their debt covenants. The construction industry uses a variety of financial ratios for various reporting purposes. Many construction companies have entered into loan agreements that require maintenance of certain debt-to-equity ratios. As a result of the new guidance, companies will be recognizing a liability that could significantly skew their debt-equity-ratio depending on the volume or size of the lease(s). This should be taken into consideration when entering into new leases or debt agreements. Contractors may also want to discuss this impact directly with debtholders prior to the first reporting period under the new guidance.