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Highlights for Contractors on the ASC 842 Lease Standard
Just as you would not begin any project without a blueprint, the same is true as you prepare to adopt Accounting Standards Codification (ASC) 842, Leases. This adoption will result in nearly all leases ending up on the balance sheet as a right-of-use asset (ROUA) and lease liability. No matter the size of your lease portfolio, it would be wise to understand how complex the implementation of the new standard can be for your company and you should not underestimate the time commitment it will take to gather and evaluate your leases for implementation.
Impact on Day-to-Day Accounting
The standard will have little to no effect on the entries construction companies make in day-to-day accounting for operating leases. When an Accounts Payable (AP) clerk receives a lease invoice, they will still post it to the job to which it relates or to an indirect cost pool from which costs are subsequently allocated to jobs. And just like ASC 840, the company will then create a monthly true-up entry to show the straight-line expense.
Liz On Leases
DHG Assurance Innovation and Methodology Partner, Liz Gantnier, recently put together a 3-part series on ASC 842:
- 10 Lease Accounting Standard Questions, Answered
- How to Plan for Implementing the New Lease Standard
- Why Choosing Lease Software Can Be Challenging
Posting Operating Lease Cost to Jobs Under the New Standard
|CASH||ROU ASSETT||LEASE LIAB||EXPENSE|
- Post expense to the job/cost pool when you get the bill as you have always done.
- Because the ROUA is amortized straight line, post a true up entry at month end close.
- Summary: there is very little impact on job costing.
ASC 842 changes this monthly true-up entry. Since the company now has a right-of-use asset and lease liability on the balance sheet, the company's monthly entry will amortize the right-of-use asset and reduce the liability. The difference will be posted to expense.
The result is the new standard should have little to no impact on the income statement and will primarily affect the balance sheet. Keep in mind, the standard does have a short-term lease practical expedient, so leases with a lease term of 12 months or less may be excluded from the balance sheet if certain criteria are met.
Bonding and Debt Covenants Impact
The right-of-use asset will be a non-current asset on the balance sheet. However, the lease liability will have a current and non-current portion, as some of the liability is due within twelve months. This may impact key financial ratios that are meaningful to contractors, such as working capital, the current ratio and the debt-to-equity ratio.
Companies that have debt and/or bonding arrangements where working capital or debt-to-equity ratios are important should begin conversations with lenders and bonding agents to discuss ASC 842 and financial covenant compliance. It is important to be proactive and ensure there is agreement with all parties as to how this standard will impact expectations. An important note is that ASC 842 does not substantially change the company's operations or obligations; it just changes how they are presented in the financial statements.
ROU Asset - Noncurrent > Lease Liability - Current and noncurrent
|Current Ratio||Current Assets/ Current Liabilities||Decrease|
|Quick Ratio||(Cash + Short-term Investments + Receivables) / Current Liabilities||Decrease|
|Working Capital||Current Assets – Current Liabilities||Decrease|
|Working Capital Turnover||Revenue/Working Capital||Increase|
|Asset Turnover||Revenue / Average Total Assets||Decrease|
|Return on Assets||Net Income / Assets||Decrease|
|Debt to Equity||Total Debt / Equity||Increase|
Related Party Leases
Under ASC 842, related-party leases are accounted for based on the legally enforceable terms of the arrangement. If a company has related-party leases with limited or no documentation, or arrangements that are “evergreen” or “perpetual,” it may raise questions as to whether such arrangements are legally enforceable. You should prepare a population of all related-party leases currently in existence and clearly document the intended terms before implementation of ASC 842, including an establishment of the lease term.
A few factors should be considered when establishing related party lease terms, especially in the case of significant office leases. First, even if the lease term is under one year, it still may need to be capitalized on the balance sheet if there are renewal options that are likely advantageous as renewal options are included in the lease term when the lessee is reasonably certain to exercise the renewal option.
Second, if there are significant leasehold improvements on the balance sheet for property or equipment, those must be depreciated over the term of the lease. If the lease term is short, this will increase the annual depreciation expense for such leasehold improvements over the shorter of the lease term or life of the asset.
Implementing the Standard
Many companies are implementing the standard now, others are planning to do it this summer. Regardless of the timing, the best place to start is with your prior-year operating lease footnote disclosure. From this approach, you can start to build your complete lease listing in order to begin the implementation process.
Identify the current lease population
Evaluate completeness of population
Summarize population of contracts and evaluate whether they include leases
How DHG Can Help
With DHG Construction, you gain accessible professionals experienced in the construction industry integrated with teams who provide a comprehensive understanding of ASC 842 and other unique reporting requirements of the construction industry.
DHG Construction works extensively with general contractors, specialty contractors, heavy/highway contractors, developers and owners, architects, and engineers. We understand the complex tax and accounting requirements of firms with substantial investments in people and equipment. DHG brings industry best practices and a collaborative approach to supporting management teams in their adoption of ASC 842. We are well-positioned to help companies with a variety of objectives regarding the new lease standard including the following*:
Services around lease identification
- Lease Compilation
- Embedded Lease Workshops
- Embedded Lease Analysis
- Lease Population Reconciliation
- Future State Process Design for Lease Identification
Services around lease classification
- Lease Classification
- Embedded Lease Classification
- Lease Classification Process and Template Design
Services around lease review & contracts
- Key Data Elements Identification
- Lease Accounting Template Population
- Lease Accounting Policy Refresh
- Lease Software Vendor Solution
- RPA Lease Extraction
Services around lease calculations
- Lease Accounting Calculations
- ASC 842 Adoption Whitepaper
- Disclosure Preparation
- Lease Rollforwards
- Technical Accounting Advice
*For discussion purposes only to illustrate how DHG can assist with the ASC 842 implementation process. Actual services delivered would follow the applicable independence rules.