If your construction company leases assets and it follows U.S. Generally Accepted Accounting Principles (GAAP), an important development occurred earlier this year. The Financial Accounting Standards Board (FASB) issued its long-awaited update revising the appropriate treatment of leases on financial statements: Accounting Standards Update (ASU) No. 2016-02, Leases (Topic 842). Affected construction companies should start assessing its impact now.
Understanding the changes
Under existing GAAP rules, how you disclose the existence of a lease on your financial statements depends on whether it’s a capital lease or operating lease. Capital leases are listed as assets and liabilities on your balance sheet. So, for instance, if you’ve leased a piece of construction equipment for nearly all of its useful life, that’s where it would go.
Operating leases, on the other hand, currently are disclosed only as a rent expense and disclosure item. In other words, they typically don’t appear on a company’s balance sheet. An example of one of these would be a lease of office space for a period of 10 years.
The FASB’s new guidance, ASU 2016-02, changes all this. It requires lessees to recognize assets and liabilities for all leases – both capital and operating – with terms of more than 12 months. You must also state the right to use a leased asset on your balance sheet as an asset and the obligation to pay rent (discounted to present value) as a liability.
In addition, ASU 2016-02 requires lessees to make additional disclosures on their financial statements. These disclosures include information regarding the amount, timing and uncertainty of cash flows related to your leases. For example, you’ll need to provide details on variable lease payments and any options you might have to renew and terminate a lease.
Discerning the classifications
The two primary classifications, capital and operating, will continue to play an important role in the accounting of leases. In fact, they’ll continue to impact your recognition, measurement and presentation of expenses and cash flows arising from a lease.
In the case of capital leases, lessees must amortize right-to-use assets separately from interest on the lease liability on their statements of comprehensive income. On your statement of cash flows, you’ll have to classify repayments of the principal portion of the lease liability within financing activities and payments of interest on the lease liability and variable lease payments within operating activities.
Otherwise, you probably won’t see a big difference in ordinary capital lease accounting – although, under the new standard, you should expect to see capital leases referred to as “finance leases” much more consistently.
Many of the changes wrought by ASU 2016-02 have to do with operating leases. For instance, lessees will need to recognize a single total lease cost, calculated so that the lease’s cost is allocated over the term – typically, on a straight-line basis. And you’ll classify cash payments within operating activities on your statement of cash flows.
Anticipating the impact
As a construction company owner specifically, you’ll likely notice the effect of ASU 2016-02 in a variety of ways. Assuming you do lease multiple assets, your balance sheet will likely get a bit longer as you add these items (as appropriate) to it. In turn, by doing so, your reported assets and liabilities will also increase. And this is where you might see the most significant impact.
A rise in reported assets and liabilities could affect the ratios that lenders and other users of your financial statements use to assess your construction company’s performance. For example, you may need to review and even renegotiate debt covenants you have in place with your lender, because your balance sheet may look less optimal. Your surety might also view your bonding capacity differently in light of the changes.
On an administrative level, ASU 2016-02 may initially increase your accounting staff’s workload. You and your staff will need to fully understand the guidance and revise your financial statements accordingly. You might also need to implement new processes and internal controls.
The good news is that you have plenty of time to gear up for the changes. Nonpublic, GAAP-compliant businesses don’t need to comply with ASU 2016-02 until annual and fiscal years beginning after December 15, 2019, and for interim periods beginning a year later. (You may adopt provisions earlier.) Work with the team at WW&D to paint a clear picture of how the guidance will affect your construction company’s financial statements.
We are here to help. If you have questions about how the new accounting standard may impact your business, please contact Dave Wolfenden at (302) 254-8240.