What the ASC 842 Lease Accounting Standard Means for Your Construction Balance Sheet
ASC 842 is a recent change to leasing standards that, among other things, requires companies to include leases longer than 12 months on their balance sheets. The ramifications of the new standard make it crucial for construction companies to get familiar with because it will likely negatively impact debt covenants with financial ratios.
Because of the potential for ASC 842 to affect such an important element of the construction business, we spoke to Chris Gorans, CPA, Audit Director with the Redpath construction audit team, for more about the standard and how construction companies can prepare for it.
An Overview of ASC 842
ASC 842 went into effect for public entities starting in 2019. After a series of delays, some related to the coronavirus pandemic, it's now slated to begin applying to private companies for calendar years ending in December 2022. The most apparent change from current US GAAP to ASC 842 is the requirement that companies include leases longer than 12 months on their balance sheets.
"For operating leases, which were never on the balance sheet before, you're adding assets and liabilities to the balance sheet," Chris says. "For each leased asset you're using, you're also going to have a liability for the future payments related to that lease." At the inception of the lease, the liability amount is often the same as the amount of the asset, but may differ depending on the terms of the lease.
What ASC 842 Could Mean for You
With lease liability reflected in new ways as a result of ASC 842, there are a number of considerations to make. Chris says that your debt covenants are the most important.
"[ASC 842] will negatively impact many debt covenants," he says. More specifically, because the new standard will increase the liabilities on your balance sheet, both current and long-term, it's going to negatively impact your ability to meet debt to equity, debt service coverage, and current ratio requirements in those covenants, among others.
Chris expects that without timely action and proper guidance from financial professionals, many construction businesses could fail to meet their debt covenants as a result of ASC 842.
What You Can Do to Prepare for ASC 842
Chris shares three main ways to position your company to stay on track and future-proof your balance sheet:
- Meet with your bank to adjust covenants. "Whether you're redoing your debt agreement now or it's coming up in a couple years, it's going to be important to know how ASC 842 will impact them," Chris says. Discuss adjusting ratios to account for the new burden that will be placed on your balance sheet.
- Take stock of your leases. With the requirements surrounding operating leases changing (and not in your favor), you may technically have more leases than you're aware of. "Anything you're making a regular payment to use could possibly be a lease," Chris says. Leases may be embedded in other contracts such as IT contracts and service contracts. Many companies have never found it necessary to track contracts that are now defined as leases. "Before, they were never on your balance sheet. You made payments and expensed them as you went." After a thorough review of contracts, many construction companies may find that they have significantly more leases to account for than they previously realized.
- Talk with your accountant. "There should be a discussion between you and your CPA," Chris says. "The rules for ASC 842 are fairly straightforward, but there are so many little things to consider – contract modifications, remeasurement requirements and non-lease components, et cetera." Needless to say, there are some potential complications that could hang up your compliance and create confusion in your finances, especially without a trusted construction accounting consultant.
While ASC 842 is not yet effective for non-public entities, it's never too early to take stock and make sure the terms of your financial obligations comply with this new standard. Get in touch with your bank and accounting firm to determine your next steps and long-term plan.