Ask an Accountant: How Changes in Lease Accounting Will Impact Builders and Contractors

by: Keith L. Eldredge, CPA, CCIFP®
Partner, Reinsel Kuntz Lesher, LLP

A new accounting standard is on the way that will have a major impact on the balance sheets of businesses across the real estate and construction industries. The Financial Accounting Standards Board (FASB) late last year voted to move forward with changes to the way leases are accounted for on company balance sheets.

What is the current practice?

Leases are typically categorized as off balance sheet liabilities. This accounting method helped with loan and bonding prequalification requirements, but some financial institutions and bonding companies would make adjustments for off balance sheet liabilities as part of the risk evaluation. FASB’s new standard will no longer allow for this treatment of leases.

What is changing and when?

Finalization of the new standard is expected to occur in early 2016, but the effective date is already slated for January 1, 2020, for most businesses. The standard will require all lease agreements that are in effect on or after January 1, 2020, to record a liability for the present value of the lease payments and change the offsetting side to a noncurrent asset. As a result, billions of dollars of these lease obligations will soon need to be included on balance sheets.

What does this mean for a builder’s books?

Let’s take a look at an example to demonstrate the change in practice. If a builder or contractor signs a ten-year lease for a building at $20,000 per month, the lease payments over that period total $2,400,000. Using an interest rate of 3.5 percent, the net present value of the lease payments is approximately $2,022,000. This would be the liability the business owner would record on its balance sheet, with the offset going to a noncurrent asset.

As with any other debt, there needs to be a current portion for the next 12 months of lease payments. In this example, the current portion of these payments would be approximately $172,000 and the offset of this transaction would show up as a noncurrent asset. The current portion of these payments will reduce working capital, which is used to determine prequalification amounts at various state agencies and some bank covenants. Booking the total amount as a liability increases a company’s debt to equity ratio, which could impact bank covenants and possibly bond programs. 

Why should builders and contractors consider this now?

Even though this is not effective until 2020, this huge change from current practice impacts businesses today. Any new leasing agreements signed today could be included in these new standards, and banking covenants, bonding programs and prequalification could also be affected. 

What action do companies need to take?

Before new lease agreements or debt agreements are signed, builders and contractors should consider how it could impact their businesses. Make sure any financial covenants are reviewed to determine if they will be negatively impacted by this change in accounting for leases. Find out how financial partners like banks or financial institutions will be interpreting this change in accounting for leases.

An accounting professional can be a valuable partner for a builder or contractor as they adapt to this major change in lease accounting. Businesses with questions about this topic or how to prepare for the new standards should contact Keith L. Eldredge at keldredge@rklcpa.com or call 717.843.3804.