Major Lease Accounting Changes to Financial Statements

Lease accounting changes are set to significantly impact financial reporting standards, especially for those preparing statements under Generally Accepted Accounting Principles (GAAP). Starting in 2022, both financing leases and operating leases will require the recording of assets and liabilities on the balance sheet, a shift from the previous distinction where only capital leases were treated this way. This update aims to enhance transparency and provide a clearer picture of a company’s financial obligations. At KatzAbosch, we are committed to helping you understand and implement these changes effectively. Watch our video to gain valuable insights into these lease accounting updates and learn how our expert team can assist you in adapting to these new requirements.

Major Changes to Financial Statements – Video Transcript

Kristin Bailey: Hey contractors, Kristin Bailey here, CPA and certified construction industry financial professional at KatzAbosch, a CPA and consulting firm specializing in construction contractors. Here with us today we have special guest speaker Claudia Walter. She’s going to go over the major changes upcoming to the financial statements. Claudia is a leading shareholder in our accounting and auditing division, and she’s also a certified construction industry financial professional as well.

To give you a little bit of background on the upcoming change, if you’re working with a CPA to prepare financial statements for a bonding company or a banker, you’re most likely using the framework Generally Accepted Accounting Principles to prepare those financial statements. There’s going to be a major change relating to leases for years ended 2022. Under the current rules, there are two types of leases: a capital lease that you put on your balance sheet as an asset and a liability, and an operating lease where you just expense the payments as incurred. Going forward, there will be two types of leases: a financing lease and an operating lease, but both of these types of leases will require the contractor to record an asset and a liability on the balance sheet. So you can see this is going to be a pretty big change.

Claudia, what is something that contractors can start to do now to prepare for this change?

Claudia Walter: Well, recently we presented a webinar on the leasing standards specifically to contractors. That webinar is on our website if you want to take a look at that. I’d say just start gathering your leases because, you know, if you have an old lease, it might be hard to find, there might be amendments. So start gathering all that information now and get it in one place so you’re more prepared as you try to implement.

Kristin Bailey: Are there any unexpected consequences of such a change as large as this?

Claudia Walter: Yeah, I think, you know, for tax purposes we’re not going to be using these standards, so we’re going to have to reverse all of these GAAP adjustments for tax purposes. So when you’re looking at your income during the year, you know this is another one of those book-to-tax differences. And you’ll want to talk to your bankers and your bonding companies about these changes as well. We’ve been trying to talk to them, but, you know, it’s still, I think, going to come as a surprise to some of them.

Debt covenants are, you know, could be impacted depending on the type of debt covenant. If you have a tangible net worth covenant, it’s possible that the bank doesn’t know how they’re going to classify these leases, so it could impact that as well as if you have a debt-to-equity ratio, you’re going to be putting a lot of debt on your balance sheet, so you want to make sure that the bankers are prepared for that because it’s going to change those calculations.

Kristin Bailey: What is the largest hurdle our contractors are going to face when implementing this change?

Claudia Walter: I think one of the things that’s really challenging when it comes to operating leases is you’re putting an asset on your balance sheet, but you’re not amortizing that asset straight line as you would typically amortize like a piece of equipment. So the amortization on that asset is a plug because the lease expense is straight line, and it’s a goofy calculation. So you’re going to either need software or a really powerful Excel spreadsheet that you put this information into. I would say, you know, you’d only want to use Excel if you have a handful of leases. If you have a lot, you’re definitely going to need some type of software. If you have like a master lease agreement where you have a lot of leases with a particular company, like for vehicles, you might want to talk to them, start talking to them now to see if they can provide you with reports to implement these standards because we’ve encountered that they do have these, so, you know, just find out about that in advance.

Kristin Bailey: What are some of the other challenges that contractors will face?

Claudia Walter: There’s a lot of disclosures around this, and there’s some things that you’re going to have to make some judgment calls around, you know, such as determining – you basically have to take the present value of your future lease stream, so you have to provide some type of interest rate or incremental borrowing rate. You’re supposed to use your incremental borrowing rate. There are some practical expedients that you can use the risk-free rate for that, but the risk-free rate is based on the term of the lease. So if you have a five-year lease versus a 20-year lease, you’re going to have a different incremental borrowing rate. And there’s just a lot of disclosures, you know, you have to calculate the weighted average remaining life and just some other kind of goofy things that are new to us.

Kristin Bailey: Any other bits of information we want to pass along to our contractors?

Claudia Walter: There are still some unknowns out there, you know, we’re not entirely sure what’s going to happen if you have a related party lease that’s a short-term lease. You’re supposed to look through to the legally enforceable terms of the lease, but if you have a related party lease that’s month-to-month and you guarantee the mortgage, it’s a three-million-dollar mortgage, you’re basically still on the hook for three million dollars. Or if you’ve put half a million dollars of leasehold improvements into a building, you’re likely not going to move out in a month. So those are some of the unknowns we’re still trying to figure out. I’d also say, you know, start gathering your leases now, look at the provisions of the lease, getting all those terms together because, you know, the more prepared you are, the less costly this implementation is going to be for you.

Kristin Bailey: Thanks, Claudia. This does sound like a very complicated and large change. So if you are a Katz Abosch client, please be on the lookout for your team member to reach out to you this year to start the conversation around leases, and if not, please feel free to contact us and we’d be happy to help answer any of your questions related to this change. So thanks for watching and I’ll see you next month.

Claudia Walter: Thanks.

To learn more about the lease accounting changes, click here to watch MCN’s Accounting Resource Group – Lease Accounting Changes…Are You Prepared on demand webinar.

Navigating the new lease accounting changes can be challenging, but you don’t have to do it alone. If you have questions about how these changes impact your financial statements or need assistance with adapting your accounting practices, our team of experts is here to help. Our construction accounting services can guide you through the new requirements, develop a customized plan to ensure compliance, and optimize your financial reporting.

Contact us today to start preparing for a smooth transition and strengthen your financial foundation.

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