Kristin’s Construction Corner-New Leasing Standard

Watch our construction accounting professionals explain what you need to know about the new leasing standard, covering the following:

• How 12/31/22 financial statements will be impacted
• How related party leases are interpreted and will impact contractors
• Using substance over form when it comes to related party leases
• Embedded leases with impact contractors
• Reviewing your contactor agreements

Transcript: 

Hi contractors! Kristin Bailey here, CPA and certified construction industry financial professional at KatzAbosch, a CPA and consulting firm that specializes in construction contractors.  Today, we’re joined by Claudia Wolter, a CPA and CCIFP as well, to chat about the changes to financial statements related to leasing.  Now, this is a huge change. Off-balance sheet leases, such as your lease for your office space,  will now be required to be on the balance sheet as a liability. There will be an offsetting asset but the impacts of this change are pervasive. This change will affect the 12/31/22 financial statements.  KatzAbosch has a ton of resources related to this change and we’re teaming up with CFMA to give a webinar on November 9. But we just wanted to take a few minutes to talk about how this impacts construction contractors specifically. So, Claudia, thanks for joining us.  What are the biggest items that contractors need to be concerned with? 

Thanks for having me today, Kristin.  So how we interpret related party leases definitely impact contractors. Most of our contractors own their own buildings or maybe multiple locations in another entity, typically an LLC. The terms of lease are sometimes ambiguous or non-existent altogether. The new standards says we need to look at the legally enforceable terms of the lease. So if there’s no lease or the lease is month to month or is a one-year period or something. But, the contractor guarantees the mortgage on the building. That guarantee is definitely legally enforceable. Therefore there’s a lease that needs to be recorded on the balance sheet. And then we’d have to look to see what term we’re going to record that and it gets complicated. 

Alright. It sounds like we’re using substance over form when looking at related party leases, and they can’t just get out of this by making something month to month. 

Exactly. So, another item that heavily impacts contractors is going to be embedded leases.  So one example that’s going to impact the construction industry is cranes. A lot of times we think about a crane as a subcontractor. You have the crane and then the operator. But if you have a crane installed on a job site, you have exclusive use to that crane. Nobody else is using that crane during that period.  Therefore you have an embedded lease and the lease should be capitalized on your balance sheet. Another example is if you have an agreement with a ready-mix plant or an asphalt plant or something like that for them to exclusively sell their product to you being the contractor.  If you have exclusive use of their product there’s an embedded lease for the plant itself.

So it sounds like contractors should start reviewing their subcontract agreements now to make sure there’s no embedded leases that they’ll need to tackle at year-end. 

Agreed. The last thing I want to mention is the impact on the change on debt covenant.  So, although there’s no effect on equity when the leases are initially capitalized on the balance sheet, debt-to-equity ratios are going to be impacted as we’re adding debt to the balance sheet. Additionally, we don’t know how banks are going to factor the new right-of-use assets in the intangible net worth covenants. If the right-of-use assets are considered intangibles, the intangible net worth ratio can be highly impacted by these leases coming on the balance sheet. 

Thanks, Claudia. It does sound like contractors should start now and not put this off until the end of the year because there could definitely be some unforeseen circumstances related to this.  So contractors, if you haven’t already attended a webinar on leasing, we have one coming up on November 9th, so please consider attending and check out our previous video blogs on leasing and, if you have any questions, feel free to reach out to us.