New Lease Accounting Rules May Add Ink to Your Balance Sheet
July 19, 2016
Does your company lease any of its vehicles or equipment? If so, and you follow U.S. Generally Accepted Accounting Principles (GAAP), some important news transpired earlier this year.
Namely, the Financial Accounting Standards Board (FASB) issued its long-awaited update revising the appropriate treatment of leases on your financial statements: Accounting Standards Update (ASU) No. 2016-02, Leases (Topic 842). Although compliance isn’t required immediately, the guidance – most commonly referred to as the lease accounting standard – will likely add some ink to your balance sheet in the future.
Under existing rules, leased business assets are accounted for in two different ways, depending on the classification of the lease in question. Companies typically recognize capital leases as assets and liabilities on their balance sheets. So, for example, if the lease term of the piece of construction equipment is for most of its expected useful life, you’d classify this as a capital lease.
Meanwhile, operating leases have been handled differently. For instance, if you signed an office lease for 10 years, you wouldn’t recognize this on your balance sheet. Rather, it would appear on your financial statements as a rent expense and disclosure item.
Under the new standard, GAAP-compliant businesses must now disclose on their balance sheets assets and liabilities all leases of more than 12 months. You can no longer separate the two classifications.
As a lessee, your company will have to report a right-to-use asset and a corresponding liability for the obligation to pay rent. But you’ll have to discount the asset to its present value using either a rate implicit in the lease or the lessee’s incremental borrowing rate.
The aforementioned classifications remain relevant, however. They’ll determine the recognition, measurement and presentation of expenses and cash flows arising from a lease.
Specifically, for capital leases, lessees must amortize right-to-use assets separately from interest on the lease liability on the statement of comprehensive income. So, on your statement of cash flows, you’ll classify repayments of the principal portion of the lease liability within financing activities. Meanwhile, you’ll denote payments of interest on the lease liability and variable lease payments within operating activities.
When it comes to operating leases, lessees need to recognize a single total lease cost, calculated so that the cost is allocated over the term on a generally straight-line basis. So, on your statement of cash flows, you’ll reclassify cash payments within operating activities.
The new standard will add other disclosures to help users of your construction company’s financial statements as well. For example, as a lessee, you’ll need to disclose qualitative and quantitative requirements — such as details of variable lease payments and options to renew and terminate leases.
In some instances, you might sign a lease for a vehicle or piece of construction equipment that includes both a leasing component and a service contract component for maintenance of the asset. The new rules will continue to mandate that businesses distinguish leasing components from nonleasing components, and ASU 2016-02 provides guidance for doing so.
The distinction between leasing and nonleasing components generally applies only to lessees. If your construction company acts as a lessor, contract consideration is done according to the allocation guidance in the FASB’s revenue recognition standard. (For more details on being a lessor, see “What if I’m the lessor?” below.)
So what will be the ultimate impact of ASU 2016-02? Assuming your construction business leases a number of assets, you’ll likely be adding more of these items to your balance sheet — increasing your reported assets and liabilities.
A change like this on your financial statements could affect the ratios that lenders and other financial statement users apply to your numbers. Existing debt covenants could be impacted, and you may face higher borrowing costs if your balance sheet looks less appealing with your operating leases included. Sureties may also re-evaluate your bonding capacity based on the changes to your financial statements.
Initially, you could also see a rise in accounting expenses. You’ll likely need to invest in continuing education for your managers and financial staff. And construction companies should establish additional processes and internal controls to ensure compliance.
Nonpublic businesses that follow GAAP don’t need to comply until annual and fiscal years beginning after December 15, 2019, and for interim periods beginning a year later. You may, however, adopt the new standard’s provisions earlier. Smith & Howard’s construction accountants can help you incorporate these changes into your construction company’s accounting practices.
What if I’m the lessor?
Some contractors have found that leasing out equipment and, in some cases, property is a useful way to create an additional revenue stream.
If your company acts as a lessor, you won’t likely encounter a major difference in your accounting practices as you comply with the new standard.
Companies that own leased assets (lessors) will see little change to their accounting from current GAAP. The new standard does, however, include some “targeted improvements” intended to align lessor accounting with both the lessee accounting model and the updated revenue recognition guidance published in 2014 (ASU No. 2014-09, Revenue from Contracts with Customers).
You might notice some minor changes, however. The new standard seeks to better align lessor accounting with the lessee accounting model, as well as with recently updated revenue recognition guidance. So, for example, lessors may be required to recognize some lease payments received as liabilities in cases where the collectibility of the lease payments is uncertain. That way, financial statement users will know more about the lessor’s leasing activities and exposure to credit and asset risk.
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