The construction and real estate industry is heavily impacted by the new lease accounting standards under ASC 842, particularly those companies that lease a significant amount of equipment or operating facilities. The way contractors account for some leases under this standard will differ from prior guidance under ASC 840 – and with the new standards becoming effective for fiscal years beginning after December 15, 2021, there’s no time to waste in preparing for this overhaul. When speaking with your banker, lender or bonding company about the impending changes to your business’s financial statements, here are some important topics to cover:
1. Key points and changes
In understanding and working through the changes with your financial statement users, be aware of the following significant modifications under ASC 842:
- Almost all leases will now be recorded on the balance sheet as right-of-use (ROU) assets with related lease liabilities.
- A new definition of a lease will apply. ASC 842 includes a new criteria for evaluating if the accounting standards apply to an arrangement. An arrangement is (or contains) a lease if it “conveys the right to control the use of identified property, plant or equipment (an identified asset) for a period of time in exchange for consideration,” as stated by the standards.
- Lease classification determination will be performed at the commencement date.
- Bright line tests for lease classification will be eliminated, and a fifth criterion added to determine whether the leased asset is specialized in nature and likely to have no alternative future use (a “finance” lease for lessees and a “sales-type” lease for lessors).
- The transfer of an asset title will no longer be required for sales-type leases of real estate.
- Lessees will be required to reassess lease term (and thus, classification) upon occurrence of a triggering event.
- There will be new distinctions of, and accounting for, lease and nonlease components. Entities will evaluate leases to separately identify lease and nonlease components and allocate contract consideration to each. Lease components will be accounted for in accordance with ASC 842, while nonlease components will be accounted for in accordance with other applicable accounting principles. Lease components are provisions of a lease that are integral to the use of an asset.
- Certain initial direct costs previously eligible for capitalization, including costs incurred before a lease is obtained, will not be capitalizable.
- The new guidance will provide sale and leaseback provisions for both lessees and lessors.
Adhering to the standards may require a detailed review of your company’s lease agreements and other contracts, which may contain lease components.
2. Evaluating your company
Construction and real estate companies that lease real and personal property will see an increase in both their assets and liabilities. This can possibly impact your financial ratios, which lenders and sureties use when evaluating your company. Further, there are several policy elections and practical expedients that could significantly affect how your financial statements are impacted, depending on your elections. Policy elections between companies may vary, and lenders must realize that comparability between entities will have to change to reflect this. It’s also important these parties understand changes to your financial statements don’t necessarily reflect a change in your contracts or operations; rather, they simply reflect mandatory accounting changes.
It’s also worth noting that the comparability of financial statements (at least on the balance sheet) may be somewhat limited in the year of adoption.
3. Understanding the difference in income statement recognition between finance and operating leases
Leases are classified as either finance or operating leases under the new standards. Although both types of leases will result in balance sheet assets and liabilities, this is still an important distinction due to the different income statement treatment of these leases. Finance leases will result in separate recognition of interest expense on the lease liabilities and amortization expense on the ROU assets being recorded in the income statement. Operating leases, on the other hand, result in combined recognition of interest and amortization expense on a straight-line basis over the life of the lease. This will ultimately result in accelerated expense recognition for finance leases compared to operating leases.
How your lenders and sureties interpret and analyze your company’s financial statements after the new standard takes effect is crucial to your eligibility for proper bonding or a loan. It is even more important that sureties and lenders understand changes under the new standards before the first required reporting date so that policy elections can be made with these requirements in mind, as well as any agreement modifications to avoid future obstacles. To speak to a lease accounting standard expert with in-depth knowledge of the construction and real estate industry, please contact us: