The COVID-19 pandemic has transformed the business landscape in the United States. Construction companies faced many new and unique challenges throughout the past year, including changes in job site working conditions to address COVID-19 concerns, unexpected delays, termination of projects as owners sought to conserve capital, and shortages of labor, materials and subcontractors. As the industry returns to a more typical operating landscape, businesses need to be aware of a new hurdle that is approaching tied to changes to the accounting lease standard. To assist with implementing these changes and maintaining compliance, we are providing details on what construction companies need to know.
The long-awaited change to the lease accounting standard ASU 2016-02, Leases (ASC 842) is effective for non-public, calendar year-end companies on January 1, 2022. Under the new lease standard, companies must record a right of use (ROU) asset and a lease liability on the balance sheet for most leasing arrangements. The new standard will impact your construction company’s financial statements and could also impact your debt covenant and other calculations.
Given the volume and diversity of leased assets inherent in the industry, construction companies face significant challenges in implementing and maintaining compliance with ASC 842. Construction businesses may lease their office space, machinery, equipment and vehicles, each with different terms and conditions.
In addition, the definition of a lease has changed under the new standard, which could result in the identification of leases embedded in service contracts and supply agreements.
How will the new lease standard impact your company?
- An increase in balance sheet assets and liabilities: Both operating and finance (formerly capital) leases are recorded on the balance sheet, and the amounts could be significant.
- A decrease in net working capital: A current portion of the lease liability could lead to a decrease in working capital, which may impact bonding capacity.
- A negative impact on your financial covenant calculations: Calculations that include the lease liability such as debt to EBITDA, debt to equity and fixed charge coverage will change and may result in noncompliance with financial covenants with lenders.
- Accounting policy and practice changes: Existing policies and practices must be reviewed and updated to ensure compliance.
Construction companies must give themselves ample time to review and identify all contracts that could contain leases, including service and other contracts. Time is also needed for businesses to develop new lease reporting methods, policies and practices as necessary. The accumulation and organization of this information are time-consuming tasks, and there is no need to wait.
What does your company need to be doing now?
- Identify the contract population. Accumulate all active lease agreements and amendments and service and other contracts that could contain leases.
- Evaluate the impact of the new lease standards on your financial statements. Develop a lease schedule to calculate the ROU asset and determine the current and long-term portions of the lease liability. Consider how reporting leases under the new standard will impact your working capital, EBITDA, debt to equity, and other key measures of importance to your company.
- Discuss implications with your surety. Educate your surety on the impact that adopting ASC 842 is expected to have on your financial statements, as well as critical ratios used in determining bonding capacity. Discuss adjustments to consider in analyzing these calculations sooner rather than later.
- Review debt covenant calculations and contact your lender. Read your debt agreements and review the covenant calculations to determine whether the calculations include debt and, therefore, could be negatively impacted. Discuss the potential amendments to your debt agreements sooner rather than later.
Given that the effective date of the new standard is quickly approaching, we encourage you to act soon. If you have any questions on implementing and maintaining compliance with ASC 842, Moore Colson can help. Contact us for more information.