NEW ACCOUNTING STANDARDS FOR LEASES WILL AFFECT THE CONSTRUCTION INDUSTRY

JOHN A. MASSARO AND TAMMY E. STRAUS JOHN A. MASSARO, CPA, has over 25 years of public accounting experience managing audits, reviews, and compilations for both public and private companies in a variety of industries including construction, real estate management, health care, and manufacturing. He also facilitated his previous firm's implementation of new accounting software and ensured the firm's staff was properly trained. John is also the president of the Chaminade High School Alumni Long Island Businessman's Association where he organizes a monthly networking event for alumni. In addition to being a licensed certified public accountant, John holds a bachelor's degree in accounting from the New York Institute of Technology at Old Westbury. TAMMY E. STRAUS, CPA, is a senior manager in Grassi & Co.'s quality control department with 20years of experience in public accounting in auditing, acquisition due diligence, and securities litigation support.While in a technical consulting role at a large firm, Ms. Straus provided clients with accounting assistance on complex financial services issues such as leasing, derivatives, and convertible financing.She has extensive experience managing SEC engagements, including initial and secondary public offerings.Ms. Straus was the primary drafter of Grassi's response letter to the FASB's 2013 Exposure Document for the Proposed Accounting Standards Update (Revised) - Leases (Topic 842). In 2010 she wrote and submitted a response letter on the original Exposure Document for the Proposed Accounting Standards Update - Leases (Topic 840). The Leases (Topic 842) exposure draft changes to the way leases are reported in financial statements of lessors and lessees. By the time the comment period ended on its exposure draft on proposed changes to lease accounting in Leases (Topic 842) in September 2013, the Financial Accounting Standards Board (FASB) had received over 600 comment letters from industry, accounting firm, and financial statement users. The FASB releases exposure drafts in advance of issuing final changes to existing accounting guidance to give the public a chance to provide feedback and suggest revisions. The Leases (Topic 842) Exposure Draft proposed significant changes to the way leases are reported in financial statements of lessors and lessees.

Currently, generally accepted accounting principles (GAAP) require companies to recognize capital leases in the balance sheet as both an asset and a liability, while operating leases are not recognized on the balance sheet. Operating lease liabilities are disclosed only in the footnotes to the financial statements. This "off-balance sheet" approach for operating leases has been criticized by many users of financial statements for distorting balance sheet ratios related to liabilities. The proposed changes would affect both lessors and lessees entering into leasing transactions, but companies can choose not to apply the accounting to short-term leases with terms of 12 months or less. For lessees, the changes would require the recognition of a right-of-use (ROU) asset and a lease liability in the balance sheet, regardless of whether the lease would have been considered a capital or operating lease under current guidance. This change would affect all industries but is especially significant for the construction industry, since it may greatly influence how lenders and bonding agents view the financial health of a company.

Overview of significant accounting changes

Under the proposed rules, the concepts of capital and operating leases would be replaced with a multistep model that would categorize leases as either Type A or Type B leases. On a simplified level, leases of assets other than real property (such as machinery, equipment, vehicles, and furniture and fixtures) would be categorized as Type A leases, while leases of real property would be categorized as Type B leases. However, there are some significant exceptions to this categorization rule. Type A leases would be presumed to cover more than an insignificant portion of the asset's total economic life or fair value. If the lease term was insignificant, however, such leases of non-property assets would be categorized as Type B instead. Conversely, Type B leases would be presumed to cover less than a significant portion of the asset's remaining economic life and fair value - but if the lease did represent a major part of the asset's life or substantially all of its fair value, such leases of property would be categorized as Type A. Regardless of the type of asset, any lease with a purchase option would be a Type A lease if the lessee had a significant economic incentive to exercise the option. The categorization is important because while the initial measurement of the ROU asset and lease liability would be the same for both Types A and B leases, the subsequent measurement and amortization of the ROU asset and lease liability would differ depending on how the lease is categorized. For both Types A and B leases, the ROU asset and lease liability would be recorded at the present value of

the future lease payments. Going forward, however, the monthly expense for Type A leases would be recorded in two different line items in the income statement. The ROU asset would be amortized on a straight-line basis over the lease term as amortization expense, while the discount on the lease liability would be recognized using the effective interest method as interest expense. In contrast, for Type B leases the amortization of the right-of-use asset would be combined with the discount on the lease liability and recorded in one line item on the income statement as lease expense. The amount would be recorded on a straight-line basis, measured as total undiscounted future lease payments divided by the lease term.

Cost of compliance considerations

For a company that only has a handful of leases, the record-keeping and compliance issues may not be too burdensome. However, many construction companies have a large number of equipment leases, and real estate companies may have hundreds and even thousands of individual leases; thus, complying with the new standards would consume a significant amount of record-keeping hours and dollars. Such companies may incur costs associated with training accounting staff on how to account for leases under the new guidance; new software may be required to help companies evaluate, track, and account for their leases.

Impact on financial statement ratios

At first glance, one may expect that the changes would not have much of an impact on the financial statements of a company, as adding an asset and a liability in equal amounts appears to net out to zero. However, for companies with significant operating leases currently, the changes may have a large impact on the computation of working capital (current assets less current liabilities). As many loan covenants contain minimum working capital requirements, the new requirement to add the liability for operating lease payments to the balance sheet could cause a company to fall out of compliance with those requirements. The ROU asset would be a noncurrent asset, while the current portion of the lease liability would be a current liability. For example, assume a company has current assets of $6,000,000 and current liabilities of $5,900,000, with a requirement to maintain $60,000 in working capital. In addition, assume it has a five-year equipment lease with payments totaling $90,000 a year, discounted at 4 percent. Under the current guidance, the

company would have positive working capital of $100,000, and thus would be close to (but in compliance with) its covenant threshold of $60,000. Under the proposed standards, however, the company would record the entry in Exhibit 1. Exhibit 1. Right-of-Use Asset and Lease Liability

After the entry shown in Exhibit 1 was recorded, the company would have only $26,000 in working capital, which would make it out of compliance with its debt covenant. Debt-to-equity and debt service ratios would also be affected by the proposed lease accounting changes because a company's debt would increase by the present value of the future lease payments. A debt-to-equity ratio that was in compliance under current guidance could turn unfavorable. For example, using the facts in the previously mentioned scenario and assuming the company has total stockholders' equity of $500,000 (and other long-term debt of $200,000), the debt-to-equity ratio would rise from 0.40 to 1.04 by adding the long-term portion of the lease liability. If the debt-to-equity covenant allowed a maximum ratio of 1:1, the company would fall out of compliance. Debt service costs would also increase due to the component of the lease payments that would be included in interest expense. In the previously mentioned example, interest expense would increase $16,000 in the first year, which is the difference between the $90,000 payment and the $74,000 present value of the lease liability in that year. As these aforementioned factors also are used in calculating a company's bonding capacity, they could have an adverse effect on the size of jobs on which a company can bid. Although the economic fundamentals of the company in Exhibit 1 have not changed in any way, it would now be out of compliance with loan covenants, and its bonding capacity would be negatively affected. What was once considered a healthy company now appears to be a poor credit risk, and the decreased ability to obtain funding would have a real, adverse effect on the financial health of the company.

Next steps for the FASB

The FASB discussed the feedback on the Leases exposure draft in their November 20, 2013 meeting, and acknowledged that there was much work to do before the guidance is finalized. Many respondents had stated in their comment letters on the exposure draft that the proposed new guidance appeared overly complex. They did not agree with the FASB's proposal to classify leases based on whether or not the underlying asset is real property, given the number of exceptions to the categorization rules. A strong theme among the responses was to consider a single model for all leases rather than either Type A or Type B, and the FASB members appeared amenable to considering this option during future deliberations. Another main theme of the responses and in the FASB's discussion of November 20, 2013 was to reconsider whether lessor and lessee accounting must be symmetrical given their different economics. The FASB's next steps are to continue its redeliberations on significant issues raised in the comment letters received throughout 2014. The FASB website has taken the issuance of the final statement off the 2014 calendar; it had been estimated as taking place in the first half of 2014 prior to the end of the comment letter period in September. Thus, the final standard will not be issued before 2015, and the effective date may not be until 2017 or 2018.

Final recommendations
Despite the FASB's reconsiderations of the Type A/Type B model, companies should not wait until the final rules are issued to consider the effects on their businesses, as it remains clear that the final guidance will require all leases to be shown on the balance sheet, even though the characterization of expenses is uncertain. Companies should consider this when negotiating long-term debt agreements and compensation arrangements in 2014 and beyond, perhaps by stipulating that any debt covenants or EBITDA calculations must be based on current U.S. GAAP or by scoping out all leases from such calculations. One of the biggest challenges will be educating banking professionals and bonding agents about these new requirements and preparing them for the changes well in advance of implementation. Existing loan agreements may have to be renegotiated or waivers granted so that companies do not fall into default because of the changes. It is important that business owners and their financial professionals become educated about these changes now and monitor updates as the FASB redeliberates its proposed guidance.

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