All contractors will be affected by the new lease standard
INSIGHT ARTICLE |
Early in 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2016-02, Leases (Topic 842), its standard on the accounting for leases.
When the guidance takes effect in 2018 for public entities and 2019 for nonpublic entities, all construction contractors’ assets and liabilities will be affected to some degree, depending on the company’s circumstances. Contractors that have historically entered into primarily operating leases will be most affected, because they will be required to recognize right-of-use assets and lease liabilities on their balance sheets for all but short-term leases.
The ASU replaces the legacy U.S. GAAP in Topic 840, Leases, of the FASB’s Accounting Standards Codification (ASC), with new lease guidance applicable to both lessees and lessors (which is included in ASC 842).
Following are highlights summarizing certain aspects of the new lease guidance that apply to the new lessee accounting model.
The new lease guidance requires lessees to classify leases as either financing or operating leases using criteria similar to, but not exactly the same as, those in legacy GAAP. Lessees are required to recognize right-of-use assets and lease liabilities for all leases not considered short-term leases. By definition, a short-term lease is one in which at the commencement:
- The lease term is 12 months or less
- There is not an option to purchase the underlying asset that the lessee is reasonably certain to exercise
For short-term leases, lessees may elect an accounting policy by class of underlying assets under which the right-of-use assets and lease liabilities are not recognized, and payments are generally recognized over the lease term on a straight-line basis.
For leases to which the election is not applied, the initial measurement of the liability is recorded by the lessee discounting the payments not yet paid over the lease term using the rate implicit in the lease, if that rate is readily determinable. If that rate is not readily determinable, the lessee’s incremental borrowing rate should be used. Lessees that are not public business entities may elect an accounting policy to use the risk-free rate for a period comparable to the lease term. If elected, this policy applies to all leases.
For the initial measurement of the right-of-use asset, the lessee starts with the amount of the lease liability and adjusts it for any lease payments made to the lessor (net of any lease incentives received by the lessee) on or before the lease’s commencement date and any initial direct costs incurred by the lessee.
Under the new guidance, how lease costs are recognized in the income statement depends on whether the lease is classified as a financing or operating lease. When there are no variable lease payments or impairment issues, the periodic costs recognized by the lessee for a financing lease are generally higher earlier in the term given the unwinding of the discount on the liability using the effective interest rate method and the amortization of the right-of use asset over the shorter of the useful life of the asset or the lease term generally on a straight-line basis.
Conversely, for an operating lease, the costs are generally recognized over the term on a straight-line basis or a more appropriate systematic and rational basis.
For right-of-use assets and lease liabilities recognized under the new guidance, lessees should either present the assets and liabilities for financing leases and operating leases as separate line items on the balance sheet, or disclose them separately in the notes to the financial statements.
Classification of lease expenses on the income statement under ASC 842 depends on the classification of the lease. If the lease is classified as a financing lease, classification of the portion of the lease expense related to the amortization of the right-of use asset and the portion of the expense related to interest on the liability should be consistent with how the lessee classifies similar expenses on its income statement (e.g., depreciation and interest expense related to the financed purchase of property, plant or equipment).
If the lease is classified as an operating lease, the expense should be included in the lessee’s income from continuing operations.
Under the new lease guidance, lessees are required to provide a variety of qualitative and quantitative information in their lease disclosures. Today, many companies utilize spreadsheets to track leases and prepare required disclosure and accounting evaluations. Given the comprehensive accounting and disclosure requirements of the new standard, companies may need to supplement their current IT systems or implement new IT systems to address these requirements. Changes to existing or implementation of new IT systems represent a significant undertaking. Therefore, companies need to ensure they evaluate and identify the appropriate IT system that will meet their requirements.
Effective date and transition
The effective date of the new lease guidance for public business entities and certain nonprofit entities and employee benefit plans is fiscal years beginning after Dec. 15, 2018, including interim periods within those years. For all other entities, the new lease guidance is effective in fiscal years beginning after Dec. 15, 2019, and interim periods thereafter. Early application is permitted for all entities.
Lessees will transition to the new lease guidance using a modified retrospective approach as of the beginning of the earliest period presented. The specifics of the modified retrospective transition approach are quite complex and differ depending on a number of factors. In addition, certain transition reliefs are available to both lessees and lessors. An option to use a full retrospective approach was not provided.
Financial statement and key financial metric effects
As noted, for most contractors, the new standard will result in the recording of assets and liabilities for substantially all leases on the balance sheet. This significant change in the balance sheet could have material impacts on key financial metrics, such as debt ratios and return on assets. Companies should evaluate the potential impacts on their key financial metrics in order to educate and inform key external stakeholders of these impacts. For example, if a construction company has a debt covenant based on its debt-to-equity ratio, its ability to satisfy that covenant after implementing the new lease guidance could be seriously compromised. It is possible that the only remedy available in this situation may be to modify the debt agreement. Contractors should consider the new guidance when negotiating debt covenants that they may be subject to when the new guidance becomes effective.