Four Effects ASC 842 Will Have on the Construction Industry
Whether you’re a general contractor, subcontractor, or any other type of construction company, you most likely have been affected by COVID-19—and so have accounting standards. On May 20, 2020, FASB voted to approve the delay of Accounting Standards Codification (ASC) 842 for an additional year for all entities that haven’t previously adopted. The new effective dates are:
- Annual and interim periods beginning after December 15, 2019, for public nonprofit organizations
- Annual periods beginning after December 15, 2021, for private companies and private nonprofit organizations
While this delay provides companies with extra time, consideration about this implementation should not be delayed until the beginning of the applicable adoption period. Now is the time to act.
What Does This Mean for Construction Companies?
Construction companies typically have leases for their corporate office, office equipment, job site trailers, fleet vehicles, and construction equipment. These leases are often operating leases under the current lease standard (ASC 840), where a company only needs to track lease payments, deferred lease asset/liability, and future minimum lease payments.
However, under the new standard, these leases will be subject to the new ASC’s guidance. A company will need to obtain additional information, such as incremental borrowing rates, as well as prepare amortization and accretion schedules. This can be difficult for older leases, as lease information might be difficult to obtain. Planning for the new standard’s effects as soon as possible is critical and can save companies both time and money in the future. So what should you expect from implementing ASC 842? Let’s explore the effects of the new standard below.
Adoption of the new lease standard requires a company to make decisions on several policy elections and practical expedients. These elections will greatly affect the information needed to implement the new standard. Companies will need to decide on the transition method, which determines the application date of the standard and the capitalization policy (materiality thresholds) to apply for ASC 842 adoption. Companies will need to decide whether to adopt a host of practical expedients, including:
- Practical expedient package, where the company elects not to reassess certain expired or existing contract and lease agreements
- Hindsight practical expedient
- Land easements practical expedient
- Combining lease and nonlease components practical expedient
Companies should determine if it’s appropriate to adopt the short-term lease exception or use the risk-free discount rate option for nonpublic business entities. The use of a risk-free discount rate instead of the rate implicit to the lease or the incremental borrowing rate will simplify adoption and implementation of the new standard. However, the use of the risk-free discount rate results in a larger right-of-use asset and lease liability, which may trigger one of the criteria for treating the lease as a financing lease.
In addition, companies will need to review service and supply contracts to evaluate if they contain embedded leases. An embedded lease occurs when the company has the right to specify the asset provided by the service provider or supplier and the company controls the use of the asset. While required under Topic 840, this review often wasn’t performed because there was no material difference in accounting for embedded operating leases and just expensing the payments as contract-related costs.
Compliance with the new standard will require increased record-keeping. Time will be spent reviewing contracts and agreements for lease and nonlease components, calculating the initial right-of-use asset and lease liability, and recording the right-of-use asset amortization and liability accretion. While right-of-use asset, lease liability, amortization, and accretion can be tracked using a spreadsheet like Excel, many companies will opt for software solutions to track leases under ASC 842. Organizations should be prepared to invest time and resources in selecting and properly implementing a suitable software solution.
Financial Statement Disclosures
The new standard requires disclosures that provide information to allow financial statement users to assess lease-related cash flows. The current lease standard includes disclosure requirements for capital leases and operating leases, but not the level of detail required by the new lease standard. Companies will need to disclose information about the nature of their leases and information about significant assumptions and judgments made in applying the requirements. Companies also will need to disclose amounts relating to the total lease costs, weighted-average lease term, lease liability balance, and weighted-average discount rate.
Compliance with Debt Covenants
Adding a right-of-use asset and the corresponding liability to the balance sheet will have a direct effect on financial metrics. These metrics would include items like working capital and leverage net debt/EBIDTA used for debt covenant and borrowing base calculations. Working capital would be expected to decrease due to the increase in the current portion of the lease liability. Net debt/EBITDA would increase, as net debt will increase while EBITDA remains unchanged.
While COVID-19 has shifted the attention of companies’ accounting departments to present-day problems such as cash flow management, Paycheck Protection Program loans, and other virus-related relief, ASC 842 shouldn’t completely disappear from management’s radar. Proper planning before adoption can reduce the amount of time spent by both management and the audit team at implementation, as well as reduce the overall scope of related fees. Plan for ASC now for savings in the future.
Need help implementing ASC 842 on lease accounting? We’ve got you covered. BKD’s three-part solution can help you implement FASB’s lease standards with ease. BKD LeaseVision uses an artificial intelligence tool when appropriate to extract key lease terms from various lease types, a road map to help provide an in-depth process framework, and an Excel-based tool to help perform calculations and develop lease amortization schedules.
If you have any questions, reach out to your BKD Trusted Advisor™ or use the Contact Us form below.