Business

Off the Books—and Back On

From balance sheets to financial statements, new lease standards are reshaping construction finance.
By James Wiedemann
August 11, 2023
Topics
Business

In the rapidly evolving world of financial accounting, recent shifts in lease accounting standards have created tectonic movements in the industry landscape. The transition from Accounting Standards Codification (ASC) 840 to ASC 842 has reshaped the contours of balance sheets and set the stage for an entirely new financial narrative. As we venture into the post-implementation phase, a closer look at the repercussions of this significant change—particularly on the construction industry’s financial statements—reveals a tale of innovation, adaptation and unforeseen challenges.

As financial professionals adapt to this new terrain, the lessons learned from this transition offer profound insights and guideposts for the path ahead.

OPERATING VS. CAPITAL VS. FINANCING

First, let’s explore the main differences between ASC 840 and ASC 842. Under the old leasing standards with ASC 840, there were two types of leases: “operating” and “capital.” There were four criteria to be classified as a capital lease:

Ownership transfers at the end of the lease.

There is a bargain purchase option (usually $1).

The term of the lease is for 75% or more of the economic useful life.

The present value of total payments is 90% or more of the fair value.

If any of these four criteria were met, the lease would be considered a capital lease. Under a capital lease, it was considered that you inherently owned the asset and should therefore recognize the asset and liability, as the lease was essentially a financed purchase—giving way to new terminology: a “financing” lease. Now, under ASC 842, there are still two types of leases, but they are “operating” and “financing.” There are five criteria for a lease to be classified as a financing lease:

Ownership transfers at the end of the lease.

A purchase option exists that the lessee is reasonably expected to exercise.

The lease term is over a major part of the economic useful life.

Present value equals or exceeds substantially all of the asset’s fair value.

The asset is specialized, whereby it only provides usefulness to the lessor.

For presentation purposes, the main difference between capital and financing leases is simply the name change on the balance sheet. Otherwise, the accounting treatment is identical to the lease established on the balance sheet as both an asset and liability for the lessor.

In contrast to capital or financing leases, we have operating leases. Historically, if a lease didn’t meet the criteria above, the accounting for it was relatively simple, because you really didn’t have to do much other than disclose it in the footnotes. You would have to record straight-line rent adjustments under ASC 840; however, we will assume there are no straight-line differences for this article.

When you think about what that means, effectively, a company could structure leases for property or equipment in a way whereby they are contractually obligated to pay potentially millions of dollars, but that future liability wouldn’t show up on the company’s balance sheet because there was no ownership over the assets. Instead, users of the financial statements would have to search the footnote disclosures to uncover this useful information.

Under ASC 842, those off-balance-sheet leases must now be placed on the company’s balance sheet as a right-of-use asset and liability. There are some exceptions to these rules for leases that are for under one year or are related party leases that are month-to-month in nature. Still, for this article, we’ll assume that all the leases are for more than one year and are not with related parties.

RIGHT OF USE

Let’s assume the following facts and circumstances: A company has five leases for various buildings and vehicles that expire at various times during the next five years. The total payments over the next year are $550,000, and the total payments over the next five years are $2.2 million. Under ASC 840, all that would be present is a disclosure in the footnotes of the financial statements showing the future payments to be made by year for the $2.2 million. Under ASC 842, the treatment is very different, as you now must record the related right-of-use asset and liability balances. To record these, you’ll have to take the present value of the payments using the risk-free rate implicit in the lease or the company’s incremental borrowing rate.

Assuming the same facts and circumstances as above, let’s say that the present value of those payments is $500,000 for the next year and $2 million over the next five years combined. To record the lease under ASC 842, the company would record a right-of-use asset and liability of $2 million. The right-of-use asset would be shown as a long-term asset on the company’s balance sheet; conversely, the right-of-use liability would be shown as current and long-term. These obligations always existed, but ASC 842 simply added transparency to the company’s commitments to the balance sheet.

Ultimately, here lies the most significant impact of ASC 842, especially concerning the construction industry. One of the most critical factors of a construction company is working capital, which by definition is a measurement of total current assets less total current liabilities. In the example above, nothing about the company has changed except adopting ASC 842. As a result, the working capital of the company has decreased by $500,000—the current liability amount. If a company is going after a specific bonding program, it may now have issues obtaining certain work with a lower working-capital balance.

FROM COMPANY TO COMPANY

If nothing at the company has changed, but the accounting treatment is now different, how are these items affecting entities? Unfortunately, to date, the treatment from the outside world has varied from company to company. Individual companies need to be cognizant of this change and make the users of their financial statements aware of its impacts early on while financing professionals across all industries adjust their benchmarks and further their understanding of this change.

For instance, a bank or bonding company with a staff person simply enters the current asset and liability amount from the balance sheet into a system. They must determine if the criteria by which they judge the entity should include or exclude these new items. If your company has financial covenants that are impacted by these changes, those covenants should be adjusted to include or exclude the amounts and potentially change the covenant target.

While this change has undoubtedly been a pain to deal with for most companies, it provides a more accurate picture of a company’s liabilities, which provides more clarity to the users of the financial statements. However, if nothing has changed with the company’s operations, the new optical balance-sheet change should not negatively impact the service that the company receives. Therefore, it’s imperative that users of the financial statements become aware of this change and either discount the amounts or move benchmarks whereby companies are judged.

by James Wiedemann
James Wiedemann, CPA is a director in the Assurance Services division of Marcum LLP’s New Haven, Connecticut, office. He provides compilation, review and audit procedures in the construction and manufacturing industries. Marcum LLP’s Construction Services group provides audit, consulting, and taxation services to clients ranging from start-ups to multi-billion-dollar enterprises. Marcum LLP's Construction Services group provides audit, consulting, and taxation services to clients ranging from start-ups to multi-billion-dollar enterprises and publishes the annual Marcum National Construction Survey, the quarterly Marcum Commercial Construction Index, the Marcum PAS Contractor Compensation Quarterly, and the annual Marcum JOLT Survey Analysis of construction employment trends--and presents an ongoing series of industry summits and technical webinars focused on the unique needs of construction contractors.

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