Lease accounting for contractors

Your guide to construction finance and accounting news

The wait is over. While there was a sliver of hope that private companies would not have to implement the new leasing standard, the day of reckoning has arrived.  On January 1, 2022, Accounting Standards Codification (ASC) 842, Leases became effective for privately held companies with December 31 year ends. This could have a significant impact on lease accounting for contractors, particularly for those with lease heavy operations.

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Lease accounting impact to the construction industry

  • There will still be two types of lease classifications (and really three):
    • Finance Leases – These are essentially capital leases under the old standard (and same accounting).
    • Operating Leases – Capitalized on the balance sheet as an asset and a corresponding liability based on the present value of future payments.
    • Short-Term Leases – Leases of 12 months or less that are expensed as incurred.
  • Since nearly all leases will be capitalized, your balance sheet will have additional “debt”. Although the underlying economics of your business remain unchanged, you should have a conversation with the users of your financial statements regarding this impact. Most lenders and sureties are aware of this change but the increase in liabilities may make your balance sheet appear weaker and can impact financial ratios and debt covenant calculations.
  • Your lease obligation will be separated between current portion and long-term portion. The asset side is all long-term. This means you will have an increase in current liabilities with no offsetting current asset. This also may impact financial ratios and debt covenant calculations.

Consideration of Related Party Leases

Many contractors lease property or equipment from related parties. These leases often are structured as month-to-month or one-year leases with annual renewals, and we have clients asking whether these can be excluded under the short-term lease exception. The guidance indicates that factors beyond the documented leases must be considered when determining how to treat these types of leases. If your company has made substantial improvements to leased property for instance, this would imply that the lease is not short term and a reasonable life to the lease must be determined and recorded. Further, if there is underlying debt related to the leased property or equipment that is guaranteed by the lessee, that would likely require the lease to be treated as long-term. Each lease is unique so we recommend speaking with your CPA to determine how they will analyze the lease in advance of preparing your financial statements.

Scope Exception

We have had some construction clients ask whether they absolutely must implement the standard. The answer is NO, BUT this would likely result in a scope exception on the CPA’s opinion letter to the financial statements. We advise you speak with any users of your financial statements how they would view that type of scope exception on your financial statements before you make the decision not to implement. Your users may have an issue with a qualified report like this.

What’s the Bottom Line?

The lease standard will change how your balance sheet and income statement will look.  What can you do?

  • Identify all your leases and document their terms.
  • Start modeling the effect of the new lease standard on your balance sheet so you understand the impact and discuss with your CPA.
  • Start talking to your banker, surety and other users of the financial statements to discuss this change.

If you have any questions about the new lease standard, contact your Henry+Horne advisor.

Matt Waller, CPA