Does your contracting business regularly lease vehicles and equipment or rely on loan agreements and surety contracts? If so, it is critical that you understand the new lease standard, ASU No. 2016-02, Leases, that requires all leases greater than one year to be reflected on your balance sheet. For operating leases with terms greater than 12 months, a “right-of-use” asset and a lease liability must be recorded at the present value of the lease payments, calculated the same as a capital lease. The standard is effective for fiscal years beginning after December 15, 2018, as well as for public business entities and fiscal years beginning after December 15, 2019. For other entities, however, early adoption is permitted.
Under current accounting guidance, leased business assets are accounted for in one of two ways: 1) Capital leases are reflected on the balance sheet as assets and liabilities; 2) Operating leases are not reflected on the balance sheet; instead, they only show up as expenses on the income statement (i.e. a rent expense from an office lease). The major change that you and your creditors need to understand is the impact of adding these previously unrecorded liabilities to your balance sheet. Users of financial statements will now have a more accurate view of your company’s finances.
How will this affect you?
- Existing loan agreements and surety contracts with debt covenants may become non-compliant due to the increase of reported assets and liabilities. Adding these leases to your balance sheet impacts common financial metrics, such as your working capital and debt-to-equity ratios.
- Increased transparency provides sureties and creditors alike more accurate information to base future bonding and lending decisions.
- A large uptick in reported liabilities could make for higher borrowing costs.
How can you prepare?
- Start identifying your existing operating leases now so you can assess whether current accounting systems are adequate to properly report them when the standard becomes effective.
- Identify leases with covenants in jeopardy of being violated, once you’ve identified your entire population of operating leases.
- Discuss with your personnel (project managers, administrators, etc.) the effects of the new lease standard and how it could affect their responsibilities.
- Communicate with your bankers and sureties about the impact of the new lease standard on existing financing agreements.
As a contractor, it’s essential for you and your creditors to understand the impact of the new lease standard. Advanced planning will mitigate the risk of breaking debt covenants and can ease the burden on your financial reporting system. For more information or questions on the new lease standard, please contact Chris Vasquez at 301.231.6244.