The old adage “the only thing constant is change” has never been more applicable. For many, this last year has felt like a race to put out one fire after another. When it comes to accounting for your construction company, getting back into a proactive mindset can help set you up for success down the line. There are upcoming changes to the way companies will need to account for leases, which will have an impact on those in the construction industry. While it isn’t at our doorstep yet, early awareness and adoption can lead to less headache in the future.
In February 2016, the Financial Accounting Standards Board (FASB) issued a new standard for accounting for leases (ASC 842), which must be adopted by all non-public companies for the calendar year ending in 2022. One of the biggest changes coming with the new leasing standard requires the recognition of right of use assets (ROU assets) and the corresponding lease liabilities on the balance sheet for many of the leases previously classified as an operating lease. Furthermore, much like how companies are required to recognize revenue based on performance obligations within their long-term contracts with clients under the new revenue recognition standards, companies will now be required to identify individual lease components (i.e. ROU assets) within a single lease contract.
Admittedly, this is an oversimplification of the new leasing standard and adopting ASC 842 will take time and analysis with your accountant. For now, we’ve highlighted two ways your construction company may be impacted by ASC 842.
Bonding and Debt Covenants
The FASB estimates that approximately $3 trillion dollars of ROU assets and lease payment liabilities are going to be added to US company balance sheets as a result of adopting ASC 842. As you begin this exercise in your own company, it is going to be imperative that you review your bonding and debt covenants and determine whether the increased reported leverage will negatively affect any key metrics or potentially cause covenant violations.
While operating lease liabilities will be presented outside of traditional debt, if you believe that violations to your bonding or debt covenants are likely to occur as a result of adopting ASC 842, we recommend that you begin having these discussions with lenders and bonding agencies now.
Income Tax Considerations
While the FASB can issue new standards for financial statements, they have no authority over the IRS or the tax code. For many, this means there are going to be additional reconciliation items between a company’s financial statements and its tax returns. These reconciliation items are referred to as deferred tax assets and deferred tax liabilities.
Once a company implements ASC 842, it will need to establish a process to account for these deferred tax assets and deferred tax liabilities. As you begin reevaluating your leases under the new leasing standard, we recommend taking the opportunity to also reassess your current tax treatment of leases as well as your data collection and process.
The Time is Now
For some, this new standard might actually be favorable and provide an opportunity to lower tax obligations. This may require a change in the method that you account for leases on your tax returns. However, the IRS considers a taxpayer’s treatment of leases to be a method of accounting, and any changes to existing methods may require IRS consent. Beginning these conversations with your accountant, lenders, and bonding agencies now can alleviate future year end surprises.
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