On Feb. 25, 2016, the Financial Accounting Standards Board (FASB) issued its long-awaited Accounting Standards Update (ASU) intended to improve financial reporting around leasing transactions. Although the standard applies to all companies that enter into leasing arrangements, the impact will be felt greater in the construction industry and other industries where equipment leasing is a major component of operations.
Under the current model, leases are classified as capital leases or operating leases, based on certain factors of the underlying leasing arrangement. Capital leases require the related leased assets and liabilities to be recognized on the balance sheet, similar to the treatment of a direct financing arrangement. Operating leases, however, do not require balance sheet recognition and have long been used as a means of keeping lease liability obligations off the balance sheet. The new ASU is intended to eliminate this method of off-balance sheet financing and create a more transparent and truer economic representation of an organization’s financial position.
Under the new model, operating leases will also require balance sheet recognition of the rights and obligations created by the leasing transaction. Organizations will record a right-of-use asset and a lease liability equal to the present value of the future lease payments. The right-of-use asset will be amortized on a straight-line basis over the life of the lease and reported as a lease expense on the income statement. The ASU permits private companies to use risk-free rates when determining the present value of lease liabilities. The new guidance also provides an exemption for operating leases with terms of 12 months or less.
The ASU is effective for public companies with fiscal years beginning after Dec. 15, 2018, and in 2019 for private companies.. The new standard requires a modified retrospective transition and provides for certain practical expedients, which if elected would allow companies to continue to account for leases that commence before the effective date in accordance with current GAAP, unless the lease is modified. Early application is permitted.
Leasing is an important activity for contractors and has served as a means of accessing operating assets and obtaining an alternative to direct financing without having to assume the full risk of ownership. Contractors enter into a large volume of operating leases for equipment, heavy machinery, vehicle fleets, office space and even construction yards. The new balance sheet recognition may negatively impact certain financial ratios that are linked to bank covenants and bonding programs, such as working capital, debt service coverage, and debt to equity. This could lead to challenges in obtaining new bank financing or additional bonding capacity as it will take banks and sureties time to adjust their compliance standards around the new reporting requirements. Contractors will need to consider this when making future lease versus buy decisions.
Although there is ample time to prepare for the new standard, companies should begin considering the impact of the change with their advisors now. The decisions made today could very well have a financial impact to contractors down the road.