March 18, 2022
Managing a construction company has become an increasingly complex proposition. Not only are the traditional project management challenges still present, but several new complexities have arisen. Primarily the increase in the cost of materials and supply chain issues have made it more difficult to provide estimates and manage work schedules. Similarly, construction accounting is complicated and impacts cash flow, liabilities, and other important information. New lease accounting rules mean companies need to immediately review lease accounting practices to ensure proper classification in financial statements. It is expected the new rules will have a significant impact on a company’s financial position which may impact banking, creditor, and surety relationships. For this reason, it is essential to conduct a thorough review of the company’s financial reporting method and lease accounting policies.
Accounting Standard Update (ASU) 2016-02, Leases (Topic 842), set forth new lease accounting requirements for financial reporting under Generally Accepted Accounting Principles (GAAP) for reporting periods beginning after December 15, 2021. That means if a contractor’s year-end is December 31, the new lease accounting standards take effect as of January 1, 2022. Contractors with a March 31 year-end would be required to recognize the new standard for the fiscal year beginning April 1, 2022.
Just like the method of financial reporting differs for accounting versus tax liability, ASU 2016-02 does not affect reporting lease payments for tax purposes.
The previous lease accounting standard saw only capital leases recorded on the balance sheet. Operating leases were reflected as expenses on the income statement when payments were made. Because operating leases stayed off the balance sheet, the related assets and liabilities also weren’t recorded. This created reporting inconsistencies and led to confusion among external stakeholders regarding the company’s true liabilities.
Under the new accounting standard, contractors will need to identify and segment finance and operating leases.
That starts with properly classifying a lease. Under the new standard, a lease is a physical asset that the contractor has the right to use or control. The asset also must be explicitly or implicitly identified. The lease and non-lease components of a contract will need to be separated. In some cases, contractors may find that a single contract contains more than one lease.
Capital leases are now referred to as finance leases. To qualify as a finance lease, one of the following criteria must be met.
With a finance lease, the asset will be capitalized and a corresponding capital lease obligation, or debt, will be recorded on the balance sheet. The asset will then be depreciated over the life of the lease. Payments are applied against the capital lease obligation with any calculated interest expensed when paid. Finally, payments due within one year on the capital lease obligation will be classified as current.
A lease is an operating lease if it does not meet any of the above five conditions. Under an operating lease, a right-to-use (ROU) asset will be recorded with a corresponding lease liability. The asset will be amortized as rental expenses over the lease term. Lease payments will be applied against the lease liability, with any calculated interest expensed as rental expenses when it’s paid. Payments due within one year on the lease liability will be classified as current, like the finance lease.
Leases with a term of 12 months or less do not need to be classified on the balance sheet.
The above changes will impact current ratios, including working capital. This is especially true for contractors with several current off-balance leases. That means working capital will likely be less at first, and the increase in liabilities may affect certain debt obligations. Contractors may want to have a conversation with their lender about the potential impact to bank loans.
All written contracts with renewal options need to be reviewed to determine the full lease period and lease obligation. This includes real estate, equipment, and any other rental-type agreements. It will be crucial to accurately record and report ongoing job costs; for some, this may also mean implementing new software and processes.
Additionally, verbal contracts do not need to be capitalized if they are month-to-month agreements and are not legally enforceable. Contractors need to consider the economic impact of moving locations. Finally, any related party transactions should also be considered and reviewed, both written and verbal.
In Perspective
If your business has not yet achieved compliance with the new standard, then it is prudent to start the process immediately. Not only will this ensure compliance with new rules but provide management with a clear understanding of how the changes will impact the company’s financial position.
About the Author
Tom Kennedy, CPA, is a Senior Manager at Wilson Lewis, an Atlanta-based CPA firm focused on serving the accounting, tax, audit, and business needs to construction companies. For additional information call 770-476-1004 or email tomk@wilsonlewis.com.