The accounting practices for the construction industry are changing due to the Accounting Standard Codification (ASC) 842 update. This update will affect how you prepare financial statements for your construction company, as well as how you record financial transactions for leases in your accounting system.
This blog will serve as an introduction and guide to the new ASC 842 lease accounting practices for construction companies. We will briefly review what the ASC 842 update is and the goals that the Financial Accounting Standards Board (FASB) looks to accomplish in regards to the accounting standards within the construction industry with this update.
ASC 842 has following key goals.
- Closing loopholes in accounting guidance associated with off-balance sheet lease accounting.
- Improving transparency, comparability and completeness of financial statements pertaining to lease liabilities.
These goals are expected to provide an additional understanding to financial statements’ users as to the true nature of financial state for a reporting entity.
ASC 842 defines a “lease” as a contractual structure in which the lessor grants “control” of a specific asset for a clearly specified duration to the lessee. In exchange for this control, the lessee pays a stated sum to the lessor broken into separate payments. “Control’ as it is used here is defined as the economic ownership of the specified asset, of which the lessee is either the sole or majority recipient and therefore receives all or the majority of the economic benefit.
Now that you know how the ASC 842 update defines a lease and the goals of the update in regard to your accounting practices, let’s discuss how these updates will affect your accounting tasks on a daily basis.
The main update you will notice under ASC 842 is in regards to how you record lease payments, liabilities, and depreciation on your balance sheet.
Prior to ASC 842, you most likely recorded lease accounting activities differently based upon the two categories of leases – operating and capital where operating leases were structured as a rental (like your office space) and capital leases were structured as financed purchases (like the equipment you pay for monthly).
Capital leases are beneficial to construction companies as they grant immediate control of necessary equipment without requiring that the equipment be paid for in full prior to receiving economic ownership of the equipment. While being granted immediate control of a needed piece of manufacturing equipment is highly beneficial to construction companies, it also significantly increases your company’s debt as shown on your balance sheet.
You may have recorded your operating lease payments away from your balance sheet in a practice known as “off-balance sheet” reporting. One of the main goals of ASC 842 is rid of this practice by increasing balance sheet reporting transparency. You will now be required to record all future lease payments as a liability on both your balance sheet and your financial statements.
If your construction company leases your equipment, you will notice an immediate impact on how you report your assets and liabilities which may significantly impact your financial debt covenants.
The first step you need to take in your updated accounting practice isn’t to make any entries in your accounting system. Instead, you need to review the lease terms and conditions of your outstanding lease agreements so you can understand and evaluate how they will affect your company’s financial position . Consider the duration of each of your lease agreements as well as the terms for renewal. You should make any renewal decisions before adopting the new reporting standards under the ASC 842 update.
Balance Sheet Presentation
Now that you have reviewed your current lease terms and have made your renewal decisions, the next step is to record your updated lease activity on your balance sheet. Your capital and operating leases will be recorded separately as Right-of-Use (intangible) assets on your balance sheet along with your total lease liabilities for each lease.
Right-of-Use assets are amortized over the term of your lease through related expirations. Lease obligations decrease as scheduled payments and are made through the term of lease agreements.
Income Statement Presentation
Finance lease – Interest expense on finance leases is presented below Income from Operations in the income statement. Amortization expense of the finance lease – Right-of-Use is presented in the operating section of the income statement as other operating assets’ depreciation expense is recorded.
Operating lease – Both amortization of operating lease – Right-of-Use and the difference between cash payments and reduction in operating lease liabilities are presented as lease expense. No amortization expense is recognized for operating leases.
Effective Dates and Transition Method
ASC 842 is effective for the period beginning after December 15, 2021. Adoption of ASC 842 must be based on a modified retrospective transition approach. There are two options for construction companies to select. The simple way is to adopt and record the impact of ASC 842 as of January 1, 2022.
While the ASC 842 certainly comes with a set of new recording guidelines, it has the potential to significantly impact financial reporting covenants. If you need some help with your ASC 842 adoption, and on-going reporting, Allen Construction Group is ready to assist. Contact us today to get started.