Does your construction business follow Generally Accepted Accounting Principles (GAAP)? And does it lease equipment, real estate or other assets? If you answered “yes” to both questions, your company should be implementing the new GAAP lease accounting standard now.
The new standard, which will be reflected in your 2022 year-end financial statements, could have a significant impact on the ratios that lenders and sureties use to evaluate your company’s financial health. Therefore, you should discuss the changes with your leadership team and, if appropriate, negotiate adjustments to loan covenants or other contractual requirements.
It’s easy to understand why the new lease accounting rules fell off the radar for many construction businesses. The Financial Accounting Standards Board (FASB) issued its new lease standard more than six years ago, followed by a series of delays in its implementation dates.
Most public companies adopted the standard in 2019, but the FASB gave private businesses an extra year to implement it, followed by a one-year delay in late 2019. After the COVID-19 pandemic hit, the FASB delayed the implementation date once again, to fiscal years beginning after December 15, 2021, and interim periods within fiscal years beginning after December 15, 2022.
Given the pandemic’s continuing economic impact, many had hoped that the FASB would postpone implementation even further. However, in November 2021, the board voted unanimously against another delay. This means calendar-year companies must apply the new lease standard beginning with their year-end 2022 financial statements and 2023 interim financial statements.
A brief refresher
Under the previous rules, leases were classified as either “capital” or “operating.” Capital leases, which generally involve a transfer of ownership of the underlying asset to the lessee, were recorded on a company’s balance sheet. In contrast, operating leases, which transfer only the right to use the asset during the lease term, weren’t recorded on the balance sheet, though they might be disclosed in the footnotes.
The new lease standard retains the distinction between operating leases and capital leases — the latter of which are now referred to as “finance” leases. Although the definitions of capital and finance leases are slightly different, in substance, they both refer to leases that closely resemble the financed purchase of an asset.
To improve transparency and financial statement comparability, however, the new standard requires both operating and finance leases to be recorded on the balance sheet. (There’s an exception for short-term leases; those with terms of 12 months or less.)
For an operating lease, the lessee records a “right-of-use” asset and a corresponding liability for lease payments over the expected term. Generally, both the asset and liability are based on the present value of minimum payments expected to be made under the lease, with certain adjustments.
Impact of the new standard
If your construction company has multiple operating leases, you might need to modify your financial reporting systems and procedures to ensure that you’re collecting the information you’ll need to comply with the new standard. In addition, you’ll have to review other types of contracts not usually viewed as leases to identify “embedded leases” that you also must record on your balance sheet. (See “Beware of embedded leases” below.)
It’ll be critical to evaluate the impact of the new standard on your financial statements. Moving operating leases to the balance sheet will increase your liabilities, which can make your financial position appear weaker or cause you to violate loan covenants tied to certain ratios.
Bear in mind that changing the way leases are reported doesn’t affect the underlying financial state of your construction business. But it’s important to discuss the impact with lenders and sureties to make sure there are no surprises. In some cases, you might need to modify your loan covenants or other agreements accordingly.
Time is of the essence
If the new lease standard applies to your construction business, and you’ve yet to begin transitioning to it, you can’t afford to wait any longer. Don’t underestimate the amount of administrative and accounting work involved in ensuring compliance. Your CPA can be an invaluable resource in understanding what you need to do and getting it done. For more information and additional resources on the new lease standard, visiting our lease accounting page.
Beware of embedded leases
To comply with the new lease accounting standard, simply reporting traditional lease agreements isn’t enough. You’ll also need to identify and account for “embedded leases” hidden in other types of agreements, such as service, supply, transportation or information technology (IT) agreements.
Under the standard, a “lease” includes any agreement that conveys “the right to control [an identified asset] for a period of time in exchange for consideration.” You possess control if you have both the right to direct an asset’s use and the right to obtain substantially all economic benefits of that use.
For example, suppose your construction business contracts with a supplier to deliver materials to jobsites. If your agreement provides that one truck from the supplier’s fleet will be dedicated solely to making deliveries to your company, the provision could be considered an embedded lease of the truck for financial reporting purposes.
Another example: Your company contracts with an IT vendor to provide a cloud-based construction management system. If the agreement requires the vendor to use a dedicated server under your control to ensure data security, the arrangement might constitute an embedded lease of the server.
These are just two of many possible examples of embedded leases. Whether a contractual arrangement constitutes an embedded lease depends on the agreement’s specific terms.