By Joseph Natarelli and James Wiedemann of Marcum LLP
Originally published February 1, 2023
After several delays due to the economic impact of the COVID-19 pandemic, the new lease accounting standards (that already applied to public companies) are now in effect for all private companies, including construction companies. The updates will affect financial statements and balance sheets for fiscal years ending after Dec. 15, 2022. Companies that have not already prepared for this change will be working overtime between now and March to ensure compliance. Let’s review how the new standards will affect your financials and strategies to mitigate the impact, plus a few common challenges businesses may face in complying with the updated standards.
OUT OF THE FOOTNOTES AND INTO THE FIRE
Construction companies often lease property and equipment that, under the updated standards, will now be recorded on their balance sheet. Any lease with a term of one year or more will need to be recorded as a right-of-use asset and liability and amortized over the full lease term. That could have a massive impact on working capital calculations throughout the industry because any long-term leases will also be recorded as current liabilities, compared to just long-term assets.
MINIMIZING NEGATIVE IMPACT
The most significant cost is associated with noncompliance. Lack of preparation or accuracy could prove an existential threat to your relationship with lenders. Even those that comply with the new requirements could be impacted: Businesses with poor record-keeping, those with many leases in place, and those with particularly high-value leases may find they have less working capital in the wake of this change. If you are unhappy with your financial statements under the new lease accounting standards, it may be a good idea to sit down with your lender or bonding partner. You can prepare them for the change to your financial statements, address any related concerns, and remind them that your business is the same stable, functioning outfit but with a new way to handle lease disclosures.
ISSUES TO LOOK OUT FOR
The devil is in the details, and each company will feel the effect of these updates a little differently. However, there are a few things likely to impact every business. To satisfy the new standards, keep these aspects of lease accounting in mind:
1. Short-term leases are exempt from the new reporting requirements, but their absence may open your financial statements to scrutiny. Generally Accepted Accounting Principles (GAAP) notices have signaled that short-term leases will be investigated to ensure companies have not employed ‘creative’ methods to circumvent the new requirements. For example, if you’re involved in a lease with a term of 12 months or less, make sure you can demonstrate that the lease is intended to be short-term and is not routinely renewed at the end of each year.
2. Interest expenses associated with leases are calculated based on the rate implicit in the lease — but in most instances that is an unknown figure. In this case, the company should use its own risk-free interest rate.
3. You’ll need to get a handle on your lease obligations by reviewing your contracts. Confirm what you owe so it can be reflected on the balance sheets, and look for any flexibility within existing agreements. For example, a clause in your contract that allows you to return equipment before the full term of the lease may impact how the lease can be represented on your balance sheet.
4. It’s not just the big property and equipment leases that are subject to the new standard — embedded leases are also affected. If you have a small trailer subleased from a client on a multi-year work site, that needs to be on the balance sheet too. If your office is leasing printers, your warehouse includes access to a truck, or your IT team is leasing software via a license, your balance sheet should reflect these agreements going forward.
ADAPTING YOUR PRACTICES
In some ways, these updated standards represent a sea change. There’s widespread concern that it may be tougher to secure financing. Crucially, though, every construction firm will be affected, so the playing field remains level. From an accounting standpoint, you should simply take information out of the disclosures and into the ledger. If you’re worried about how this change will impact your business, meet with your financiers early to reassure them that your balance sheets and financial statements are thorough, accurate, and compliant. Not only will they appreciate your timeliness and accuracy, but it may also help build trust that pays off the next time you seek financing.
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Article is reprinted with permission from Marcum LLP and originally appeared on marcumllp.com.
Joseph Natarelli is office managing partner of Marcum's New Haven, Connecticut office and a member of the Firm’s Executive Committee. Natarelli also serves as national leader of Marcum’s Construction Services practice, overseeing audit, consulting, and taxation services to construction clients ranging from start-ups to multi-billion-dollar international enterprises. He can be reached at joseph.natarelli@marcumllp.com or 203.781.9710.
James Wiedemann is a director in the Assurance Services division of Marcum LLP. He has more than 11 years’ experience providing compilation, review, and audit procedures in the construction and manufacturing industries. He can be reached at james.wiedemann@marcumllp.com or 203.781.9721.