On Feb. 25, 2016, the Financial Accounting Standards Board (FASB) issued its long-awaited revision to lease accounting, a standard that impacts most industries, but has particular relevance to construction and engineering.
Leasing serves as a critical tool in the industry. Construction equipment, office trailers, and vehicles, for example, are used to complete almost all construction projects, allowing use of property, plant, and equipment without large initial cash outlays. In many cases, the contractor leases these assets for the duration of the contract and either returns or acquires the leased assets at the end. In other situations, these assets are owned by the contractor but utilized on a contract and then moved to the next contract upon completion.
The distinction is that assets leased for a long-term construction project typically are recorded as an operating lease under current accounting rules and, therefore, are not on the contractor’s balance sheet. Most contractors believe current accounting is aligned with the true underlying economics of the transaction, as the benefits of the leased assets are in fact being realized by the project owner, and not the contractor. As such, assets are simply being used to facilitate the completion of a project rather than being used for general business purposes.
However, the new lease accounting standard will, in almost all cases, put these assets on the balance sheet of the contractor as if the assets were owned, along with a related liability for the present value of the lease payments. These arrangements will require specific and on-going analysis to determine proper financial statement reporting and will require reassessment when circumstances change. This change in accounting will have an impact on not only financial reporting but also tax reporting, information system requirements, operational decisions and reporting, and government contract revenues.
For some, FASB’s leasing standards may not seem like a very big deal. At a very high level, it means companies just need to report all but short-term leases on their balance sheet. Seems simple enough, right? But this false sense of security could be exactly what ends up hurting construction and engineering companies as they near calendar year 2019 (public companies) or 2020 (private companies) effective dates set by the FASB for implementation.
Where to begin
Unfortunately, it’s likely that construction and engineering companies are underestimating just how much time will be needed to adhere to these guidelines. This is a problem. If you don’t know where to begin, here are a few tips:
First, do as much as you can as soon as you can to minimize the overlap between a second major change in accounting standards the revenue recognition conversion and work necessary to adhere to the new leasing standards. In May 2014, the U.S. and International Accounting Standards bodies FASB and IASB issued their converged standard on revenue recognition, which provides a comprehensive, industry-neutral revenue recognition model intended to increase financial statement comparability across companies and industries.
The good news here is that most public companies have already dedicated resources to this shift to meet the calendar year 2018 deadline. The concern is that revenue recognition and leasing standard implementation projects are extremely labor intensive and will most likely overlap, straining your resources.
Therefore, it’s imperative that construction and engineering companies focus a concerted effort on getting through the revenue recognition conversion process as soon as possible. This will allow for those resources to free up time to devote to complying with the leasing standards in advance of any pending deadlines.
Second, develop a process for gathering the data you need to comply with the new leasing standard. Data is a huge issue for the construction industry. You will need to gather a complete inventory of leases, including arrangements that may contain an embedded lease, such as service contracts. Companies will need lease data that is complete and accurately extracted and validated, which could prove challenging as you consider where your contracts are, what comprises the key terms, and aspects specific to the industry, such as terms that may apply to multiple construction sites. For larger companies, this could also involve reviewing and updating current data collection and storage systems. It’s fairly easy to underestimate just how labor intensive this can be.
Many companies use spreadsheets to account for leases. The ongoing reporting and expanded disclosures may require businesses to implement a leasing system and enhance its process. Systems and procedures around leased assets are often at the job site, the home office, or even operated through a separate entity altogether. Better coordination and an enhanced or more focused process around procurement and job allocation will be required. Taking the time to evaluate this now will save time in the long run. As such, there is no better time to evaluate your procurement processes. As you gather all of this data in one centralized location, this should bring an opportunity to maximize returns on owned assets and make it clear when you have excess assets or assets that are underutilized by managing all assets through one central group.
Third, don’t forget the importance of taking a critical look at your current leasing decisions. The traditional lease-versus-buy decision will take on new meaning under the proposed rules as leased assets will generally be on the books irrespective of whether they are owned at the end of the lease. The key is to balance making the right economic decision while understanding the impact to the financial statements.
Many contractors utilize an equipment cost center or department to oversee, maintain, and “rent” owned equipment to its construction contracts. This has helped maximize equipment utilization, achieve economies of scale in the negotiation process, and properly cost its contracts, ensuring that all direct and indirect costs are considered. The rates that are developed to charge a contract are generally similar to third-party lease rates and typically accepted as a reimbursable cost on cost-plus contracts (including government contracts following Federal Acquisition Regulations or FAR) or modifications to other contracts.
Contractors should consider putting all construction-related tangible assets, both leased and owned, through this cost center if not already done. This will help lease-versus-buy decisions yet preserve job-specific economics by charging the contract rent similar to historical practices and consistent with how the contract was bid and managed from the field. This would also allow for tracking equipment rental for tax reporting purposes and capturing some of the residual guarantees that often accompany synthetic and other lease-specific terms as well.
Bottom line: Time is of the essence, and not just for public companies, but also for private companies. If your business is private but you have international subsidiaries, you will not get the one-year deferral allowance for IFRS reporting, and, therefore, you may need to adapt to the new leasing standards according to the same timeline as public companies do.
It’s clear that these changes to the leasing standard will have significant implications for matters far beyond traditional financial reporting, such as operations, tax compliance, information technology, stakeholder communication and reaction, and potentially cash flow. Businesses that plan and prepare early for the leasing standard will be those best positioned to drive the most value across their organizations. Though complex, properly implementing the leasing standard should provide your organization with an opportunity to re-evaluate its needs and find new efficiencies and opportunities for transparency.
Kent Goetjen is a partner in PwC’s (pwc.com) Hartford, Conn., office and is the firm’s U.S. Engineering & Construction industry sector leader. He has more than 30 years of experience providing service to the engineering and construction sector.
Sheri Wyatt is a managing director in PwC’s Capital Markets & Accounting Advisory Services based in the firm’s Chicago office. She has more than 14 years of experience in leasing transactions.