The True Impact of ASC 842 Lease Accounting Standards on Your Construction Business
Construction businesses must now adapt to new lease accounting standards that will affect their financial statements more than expected. The Financial Accounting Standards Board (FASB) amended the accounting guidance for leases through an Accounting Standard Update (ASU 2016-02, Leases) in February 2016. The COVID-19 pandemic delayed implementation, but these standards now apply to all private companies, including construction businesses.
The new lease accounting standard ASC 842 requires companies to record every lease longer than 12 months on their balance sheet. Construction companies must list these leases as ‘right-of-use’ (ROU) assets with corresponding liabilities. This change took effect for private companies’ fiscal years starting after December 15, 2021. The construction industry faces its biggest change from legacy GAAP through this update.
Let us guide you through ASC 842 lease accounting standard’s effects on construction businesses. Your balance sheet, income reporting, and unique implementation challenges deserve attention. Companies that haven’t prepared for these changes should act now. Understanding these requirements will help shape accurate financial reporting for years ahead.
Understanding ASC 842 and Its Purpose
ASC 842, the lease accounting standard, serves as the foundation for financial transparency and has changed how construction businesses report their leases. Let’s understand the reasons behind this change and what it means for your company.
Why the lease accounting standard update was introduced
The Financial Accounting Standards Board (FASB) brought in ASC 842 to fix a big gap in transparency. Under the old ASC 840 rules, construction companies could simply tuck away their leases in financial statement footnotes instead of showing them in actual financials. This practice left investors, vendors, government agencies, and other stakeholders in the dark about companies’ true financial positions and risk exposure.
Companies’ financial results were nowhere near comparable because of this lack of transparency. ASC 842 will give stakeholders a clear view of a company’s actual lease commitments, which leads to better decision-making.
Key differences from previous lease accounting rules
The biggest shift between ASC 840 and ASC 842 relates to balance sheet reporting. The new standard requires companies to record all leases longer than 12 months right on the balance sheet, unlike before when operating leases stayed “off balance sheet”. These leases now fall into two categories: “Finance” or “Operating” leases.
Here are other important changes:
- More detailed disclosure requirements replaced the basic five-year commitment table that showed future minimum lease payments
- New weighted-average disclosures show discount rates and lease terms
- The standard lines up better with international lease accounting standard IFRS 16, especially in how leases are defined
Effective dates for construction businesses
ASC 842 became mandatory for all private companies, including construction businesses, after several delays. The requirement kicked in for fiscal years starting after December 15, 2021. Private companies that report on a calendar year had to adopt ASC 842 by January 1, 2022.
FASB pushed these dates back because public companies struggled with implementation and COVID-19 caused unprecedented disruptions. But a July 2021 report showed that 75% of surveyed private companies still weren’t fully compliant with ASC 842.
How ASC 842 Changes Your Balance Sheet
The new lease accounting standard requires companies to record virtually all leases on their balance sheet. This radical alteration changes how construction companies show their financial position to investors, lenders, and other stakeholders.
What is a right-of-use (ROU) asset?
A right-of-use asset shows your construction company’s privilege to use a leased item during the agreed-upon lease term. This new asset category appears on your balance sheet and reflects your right to control and get economic benefits from leased equipment, vehicles, or property.
The original ROU asset value matches your lease liability plus prepaid rent, minus remaining deferred rent and lease incentives, plus direct costs at the start. Simple leases without these extra factors will have similar ROU asset and lease liability values at first. Both operating and finance leases need ROU assets, though their amortization differs based on classification.
How lease liabilities are calculated
Lease liability shows your financial obligation to make lease payments, measured on a discounted basis. Here’s how to calculate this amount:
- Identify all remaining lease payments over the lease term
- Determine the appropriate discount rate (implicit rate in the lease or your incremental borrowing rate)
- Calculate the present value of those payments
Private construction companies can use a risk-free rate instead. The calculation includes fixed payments, expected residual value guarantee amounts, purchase option prices if exercise is reasonably certain, and any termination-related payments.
Short-term lease exemptions and their risks
ASC 842 offers an optional exemption for short-term leases—those lasting 12 months or less at the start without a purchase option you’ll likely exercise. This exemption lets you treat these leases like operating leases under the old standard, keeping them off your balance sheet.
Companies must apply this policy election consistently by asset class. While this exemption saves time and resources, it has risks. Your lease might need immediate balance sheet recognition if a reassessment extends its term beyond 12 months. On top of that, it requires disclosure in your financial statement footnotes.
Lease Classification and Income Statement Impact
The classification between finance and operating leases affects how construction businesses handle their expenses and cash flows under the new lease accounting standard ASC 842. This classification is vital for accurate financial reporting.
Finance vs. operating leases under ASC 842
A lease becomes a finance lease when it meets at least one of these five criteria:
- The lessee gets ownership when the lease ends
- The lessee has a purchase option they’ll likely use
- The lease term covers most (typically 75% or more) of the asset’s remaining economic life
- Lease payments’ present value equals or exceeds 90% or more of the asset’s fair value
- The asset is unique and the lessor can’t use it for anything else
The lease becomes operational if none of these criteria are met.
How each lease type affects income reporting
These lease types report income differently. Finance leases need separate reporting for interest expense on lease liability and ROU asset amortization. Companies pay more in earlier periods because of this front-loaded expense pattern.
Operating leases work differently. They use a single lease cost spread evenly across the lease term. This creates steady expenses throughout the lease period. The expense types also vary – finance leases look like interest and depreciation costs, while operating leases show up as operating expenses.
Cash flow statement changes to expect
The lease accounting standard changes how businesses report cash flows. Finance lease principal payments fall under financing activities, and interest payments count as operating activities.
Operating lease payments are simpler – they all count as operating activities. There’s just one exception: payments that help prepare another asset for use should be listed as investing activities. Payments for short-term leases and variable costs not in lease liabilities also stay in operating activities.
Construction-Specific Challenges and Considerations
Construction companies struggle with unique challenges when implementing ASC 842 lease accounting standards. These challenges go way beyond regular compliance issues and need special attention to keep financial reporting accurate.
Identifying embedded leases in subcontractor agreements
Construction firms need to get into their subcontractor agreements to spot potential embedded leases. A contract creates an embedded lease when someone gets the right to control a specific asset for a while in exchange for payment. The most common examples show up in construction sites. You’ll see this with frameworks (which you can’t swap out once they’re set up), cranes (that come with no substitution rights), and temporary fencing. Equipment from subcontractors that stays on site for long periods often counts as an embedded lease. The core team should look for these four things in contracts: a specific asset, control rights, a set timeframe, and payment terms.
Including lease costs in job costing and revenue recognition
Getting lease costs into job costing systems creates real headaches. Before, contractors just charged monthly subcontractor invoices to projects. Now with ASC 842, these embedded leases need to show up as right-of-use assets with matching lease obligations. Companies need to spread these costs correctly over the lease period to the project. This changes how gross profit works out, especially for leased equipment on job sites and transportation fleets.
Effect on bonding capacity and lender relationships
The standard changes key financial metrics that sureties and lenders review. Working capital usually drops because the current part of lease liabilities shows up as a current liability, but the right-of-use asset stays non-current. This is a big deal as it means that a contractor’s bonding capacity might drop by up to 10 times the working capital reduction. Debt-to-equity ratios go up as lease liabilities grow without matching equity changes. Companies need to talk to their lenders early about these accounting changes to adjust lending agreements if needed.
Handling lease modifications and remeasurements
Lease changes need careful tracking and a fresh look. A modification means “a change to the terms and conditions of a contract that results in a change in the scope of or the consideration for a lease”. Changes can include longer or shorter lease terms, new usage rights, or different payment terms. Each type of change needs different accounting treatment – either as new contracts or by recalculating existing leases. Construction companies must set up systems to track these changes throughout their projects.
Conclusion
ASC 842 marks a watershed moment for construction businesses nationwide. Compliance might seem overwhelming at first, but understanding these new lease accounting standards results in greater financial transparency. Construction companies now need to show their complete lease commitments on balance sheets instead of burying them in footnotes.
This transition brings unique challenges for contractors. They must pay close attention to embedded leases in subcontractor agreements, job costing system changes, and how these affect bonding capacity. As a result, many construction businesses need to change their accounting processes. Some might have to negotiate new terms with lenders who depend on traditional metrics.
The difference between finance and operating leases plays a crucial role, especially since each type affects your income statement in its own way. Financial teams should carefully categorize leases to ensure they report expenses and cash flows accurately.
These challenges aside, ASC 842 compliance brings real benefits. It gives stakeholders a better view of your company’s true financial position. The standardized approach matches international reporting standards and makes financial statements easier to compare across the industry.
Companies can no longer wait to prepare – they must act now. Contractors who tackle these requirements head-on will stand out from competitors who still don’t deal very well with implementation. We suggest you review your lease portfolio right away. Talk to accounting professionals who know construction-specific issues and be open with your financial partners about these changes. Embracing these standards goes beyond compliance – it shows your steadfast dedication to financial integrity in an industry built on trust.
