Tips for Construction Companies Implementing ASC 842
In my first article, I discussed some of the impacts of ASC 842 specific to the construction industry (WILL INCLUDE LINK TO FIRST DRAFTED ARTICLE HERE). This article addresses the new standard from a more technical perspective to give management some tips on implementation.
ASC 842 Significant Changes
- All leases that include the right to control a specifically identified asset with a lease term longer than twelve months are required to be recorded as a right-to-use asset with an offsetting lease liability on the balance sheet. The calculation of the right to use asset and lease liability upon lease inception is very similar to the calculation for a capital lease under current GAAP.
- The lessee must determine if a lease is a finance lease or an operating lease. A lease is a finance lease if:
- Lease transfers ownership of an asset on or before the end of its term;
- Lease gives the lessee option to purchase the asset and lessee is reasonably certain to exercise that option;
- Lease term represents the major part of the remaining economic life of the underlying asset;
- PV of lease payments and any guaranteed residual value equals or exceeds substantially all of the fair value of the underlying asset; or
- The asset is so specialized for a particular purpose it has no other use.
For those familiar with current GAAP, you will notice that these criteria are very similar to the capital lease determination criteria. As such, in most cases, it is likely that if a lease was determined to be a capital lease under current GAAP, it will be a finance lease under ASC 842. The only practical difference in accounting for a finance or operating lease is the monthly journal entries that will be recorded to amortize the lease liability. Finance leases will include components of amortization expense and interest expense; operating leases will only include “lease” expense.
ASC 842 Key Terms and Caveats
Specifically identified asset
The lessee must determine whether the lease is for a physical identifiable asset or whether the supplier has significant substitution rights. In the construction industry, it is probably likely that the asset will be identifiable. Many times a contractor may lease the rights to use a piece of machinery or equipment that would remain on the job site for its duration. In this case, this criteria would be met. However, such assets may be for durations less than one year and thus not require recognition of the right to use asset and lease obligation.
Right to control
The lessee should consider whether it has decision-making rights that will most affect the economic benefits derived from the use of the asset. In more general terms, essentially as long as the lessee has the rights to direct how and for what purpose the asset is used, this criteria is met.
this definition is a very important piece to implementing the standard, and serves to close a “loophole” that many companies may have applied. The lease term is defined as:
- Periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option
- Periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option
- Periods covered by an option to extend (or not to terminate) the lease in which exercise of the option is controlled by the lessor.
The practical implication and purpose of this definition is to address certain related party leases that are common in the construction industry. In cases where a company leases a building from a common-controlled entity, the new lease standard must be applied even if the stated lease period is less than twelve months, assuming that the lease is reasonably likely to be extended. In cases where a lease is reasonably likely to be extended into perpetuity or with no expected termination in sight, management should consider other relevant economic factors, such as the remaining length of the loan on the underlying leased asset.
The guidance under ASC 842 is effective January 1, 2020, and will have a significant impact on the balance sheet of the vast majority of companies. We suggest that management begin to understand how it will be implemented and the best strategy for doing so.
Keiter is always available to help with this process, and would love the opportunity to discuss any uncertainties or questions that may arise during the implementation phase of this new standard.
The information contained within this article is provided for informational purposes only and is current as of the date published. Online readers are advised not to act upon this information without seeking the service of a professional accountant, as this article is not a substitute for obtaining accounting, tax, or financial advice from a professional accountant.