In February 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update 2016-02, Leases (Topic 842), which made significant changes to lease accounting. These new rules are in effect for private companies with fiscal years beginning after December 15, 2019, in other words, 2020 for companies with a calendar year end. While publicly traded business entities are already using the new standard, it’s worth noting that there has been strong support from the AICPA to delay the implementation date at least one year, meaning that private business entities with a calendar year-end would not have to adopt the new standard until 2021, though any potential delays are still pending. The FASB discussed this delay in their July 17, 2019 board meeting, with an exposure draft being released on August 15, 2019. Exposure drafts have a comment period of 30 days, which ended September 16, 2019; therefore we are currently awaiting the results of that comment period.
If your company follows generally accepted accounting principles (GAAP) it’s time to start preparing for the new standard if you lease real estate, equipment, vehicles, or other property. This new standard will impact both the assets and liabilities recorded on your balance sheet; therefore, the new rules may affect the financial ratios that lenders and sureties use to evaluate your business’s financial health, especially when comparing them to prior years.
Historically, leases have been classified in one of two ways, either a capital lease or an operating lease. A capital lease, generally involved a transfer of ownership of the underlying asset to the lessee and was recorded on a company’s balance sheet. Conversely, an operating lease merely transferred the right to use the asset during the lease term. Operating leases had no balance sheet impact and were expensed throughout the lease term. Capital leases were previously recorded on the balance sheet and their treatment is relatively unchanged. The previous guidance, specifically in relation to operating leases, failed to represent fully the actual substance of leasing transactions by not recognizing assets and liabilities arising from these operating lease transactions.
To increase transparency and financial statement comparability, the new standard requires nearly all leases to be recorded on the balance sheet, with an exception for some leases with a term of less than 12 months. The new guidance retains the distinction between finance leases and operating leases, similar to the capital and operating lease distinctions in the previous guidance. Under both finance and operating leases however, the lessee records a right-of-use asset that reflects the value of its right to use the leased property during the lease term, as well as a liability that reflects its obligation to make lease payments. The distinction between an operating lease and a finance lease is the recognition of lease-related expenses on the income statement.
Operating vs. Finance Leases
When determining whether or not you have an operating or a finance lease, there are five questions that must be considered. You will notice that these are very similar to the consideration under the previous guidance of an operating vs. capital lease.
- Does the lease transfer ownership of the identified asset to the lessee by the end of the lease term?
- Does the lease give the lessee the option to buy the asset at the end of the term? If so, is the lessee reasonably certain it will exercise this option?
- Does the lease term cover a majority of the remaining economic life of the asset – this is defined as 75% of the assets useful life.
- Is the present value of the sum of the lease payments equal to or greater than the fair value of the asset? Note: Non-public companies are permitted to use a risk-free discount rate to calculate the present value of the lease. The risk-free rate is the effective risk free rate at the lease commencement date.
- Is the underlying asset of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term?
If the answer to any one question above was ‘yes’, than the lease in question is a finance lease. If the answer to each of the five questions above was ‘no’ than the lease in question is an operating lease. This consideration will have to be made for each individual lease agreement.
Below is a brief summary on how each type of lease is accounted for:
- Generally, the amount recorded, for both the asset and the liability, is the present value of minimum payments expected to be made under the lease, with certain adjustments. Liabilities should include optional periods if management makes the determination that it is reasonably certain that the option(s) will be exercised. Management needs to make this determination at the commencement date. This same determination will have to be made when considering whether month-to-month leases can be excluded from the balance sheet, as previously discussed. If management determines that it will likely renew a month-to-month lease for a period of time that extends past 12 months, the lease will need to be considered either an operating or finance lease.
- Single expense is recognized (rent expense) that runs through operating activities for the current year to relieve the right-of-use asset. Costs are allocated over the lease term on a straight line basis.
- Right-to-use asset and lease liability are both recognized and discounted to present value, which is the same calculation referenced in the operating lease discussion above.
- Each rent payment has two components (interest and principal). Interest is a current period interest expense. Principal is amortized to reduce the right-to-use asset (similar to how depreciation on a capital lease is currently reported).
- Repayment of principal portion of lease liability is a financing activity on the statement of cash flows. Payments of interest are operating activities on the statement of cash flows.
While these general rules will apply to a “standard” lease, there are several carve outs and practical expedients that can be taken, especially for privately-held companies. This can help make the implementation of this new standard less burdensome. It’s recommended that you consult with your CPA to discuss how.
Will you be viewed differently?
If your company has significant operating leases, it’s important to talk with your lenders and sureties about the potential impact that the new lease standard will have on you financial statements. Keep in mind that moving existing leases onto the balance sheet merely changes the way these leases are reported. It doesn’t change your company’s underlying economics, and most lenders and sureties understand this. However, if discussions aren’t occurring now, a sudden and unexpected increase in liabilities may make your balance sheet appear weaker, and cause concerns for both lenders and sureties. It’s important to start these discussions as soon as possible so that everyone is on the same page.
If your company’s financing agreements contain financial covenants that are tied to debt to equity levels, or other ratios that take into consideration the amount of debt a company holds, you should evaluate the impact of the new standard on these key financial ratios, because in some cases, increased liabilities can cause you to violate loan covenants.
As you discuss loan covenants with your lenders, ask them to consider building some flexibility into the covenants to avoid violations triggered by future changes to accounting standards. For example, some covenants provide that, if implementation of a new accounting standard changes a financial ratio, either 1) the change won’t be deemed a violation, or 2) the parties will be required to renegotiate the covenant.
Are you ready?
If your construction business is engaged in significant leasing activity, work with your CPA to review your leasing arrangements and evaluate the impact of the new lease standard on your company’s financial statements. In addition, contact your lenders and sureties before you implement the new standard to discuss potential changes to your company’s balance sheet and ensure a smooth transition.