In 2016, the Financial Accounting Standards Board (FASB) introduced new lease accounting standards, fundamentally altering how businesses report leases on their financial statements. These standards became effective for most private entities and nonprofits in 2022. As construction companies navigate through their second year of compliance with the new lease accounting standard, it’s essential to understand how these changes impact their balance sheets and what potential alterations are on the horizon.
Recording Leases on the Balance Sheet:
Construction companies are now required to include leases with terms of more than one year as “right of use” (ROU) assets and corresponding liabilities on their balance sheets. This new standard represents a significant change in how their financial statements are presented.
This change particularly affects the way construction companies record their property and equipment leases. Any such lease with a duration exceeding one year must now be reflected on the balance sheet.
Discount Rates:
A critical aspect of implementing these standards is determining the present value of future lease payments, for which a discount rate must be applied. Construction companies often face challenges in determining this rate, making using either the incremental borrowing rate or the risk-free rate more common.
Terminated and Modified Leases:
Understanding the treatment of terminated and modified leases is crucial for accurate reporting.
Partial Termination vs. Lease Modification:
Determining whether a lease has been partially terminated or modified can be complex, but it’s essential to get it right. For instance:
- Decreasing leased space constitutes a partial termination.
- Leasing additional space in the same building indicates a lease modification.
- Revoking the lessee’s right to use an asset is a partial termination.
- Extending the lease term signifies a lease modification.
Remeasuring Leases:
When lease modifications occur, remeasurement might be necessary. This involves reallocating remaining consideration and applying updated discount rates.
Issues to Look Out For:
While we’ve delved into technical aspects, construction companies should keep these key points in mind:
- Ensure short-term leases are not routinely renewed to avoid scrutiny.
- When the implicit rate is unknown, use your own risk-free interest rate.
- Review contracts to confirm lease obligations and explore flexibility within existing agreements.
- Don’t overlook embedded leases, such as subleases or software licenses.
Changes Coming in 2024:
While the lease accounting standard remains the same in 2024, the FASB has introduced Accounting Standards Update (ASU) 2023-01, addressing common control lease arrangements. This update offers practical expedients to reduce administrative burdens and allows private entities to amortize leasehold improvements over their useful life, benefiting control groups.
Potential Challenges and Strategies:
As construction companies navigate these changes, several challenges and strategies come to the forefront:
Short-term Leases:
Short-term leases are exempt, but misuse may raise scrutiny. Ensure that leases intended to be short-term are not routinely renewed.
Interest Expenses:
Calculating interest expenses can be challenging when the implicit rate is unknown. In such cases, use your risk-free interest rate.
Reviewing Contracts:
Review contracts to confirm lease obligations and explore flexibility within existing agreements.
Embedded Leases:
Don’t overlook embedded leases, such as subleases or software licenses, which must be reflected on the balance sheet.
The new lease accounting standards have ushered in significant changes for construction companies. These companies must understand how these changes impact their balance sheets, financial statements, and strategies for compliance. Proactive engagement with financiers and meticulous evaluation will be vital to navigating these accounting shifts successfully.
Construction companies can adapt to these changes in a dynamic financial landscape, ensuring their financial reporting aligns with the evolving standards and remains transparent and accurate. If you have further questions or need assistance implementing these standards, consult our financial professionals to ensure compliance and financial stability.
