As the year draws near its end, construction company owners and their fiduciaries should keep a close eye on an accounting change recently proposed by the Financial Accounting Standards Board ( or FASB). Depending on the industry’s response this year, the change could go into effect in 2011.
The focus of the change is leasing, including equipment leasing. If enacted it likely will have a sizeable impact on construction companies, and here’s why: Under current standards, leases are split into two categories: capital leases, which must be reported on balance sheets, and operating leases, which are allowed to stay off the books if worded correctly in contracts. FASB believes this creates an understatement of assets and liabilities, and allows companies to structure leases to achieve goals such as higher profits, while making it harder to compare results of firms that treat leases in different ways.
What FASB is proposing instead is a system that gives investors a complete picture of any company’s leasing activities when those investors view the balance sheet, including variable features such as renewal options and contingent rentals. Existing leases would not be grandfathered and would be immediately subject to the new rule. If adopted, the change could lead to a sharp increase in the number of construction companies reporting higher debt. For leases of 12 months or less, lessees and lessors would be able to apply simplified requirements.
For those of us in the industry who work to keep costs down, this proposal is like salt in a wound. Lessees would be required to perform significantly more monitoring and record keeping, particularly for leases currently classified as operating leases. Auditors would be relieved of making some of the subjective judgments required under the current model, but would be required to make other judgments and potentially perform more detailed audit procedures due to the increased quantity of leases reported and the necessity of assuring that all leases are reported.
Another concern is that lenders and sureties would have to consider the recording of the operating leases as current and non-current liabilities that would negatively affect working capital and debt-to-equity ratios. Loan covenants would need to be modified for this change in Generally Accepted Accounting Principles.
There is a positive element to the proposal: Leases with built-in price adjustments would be properly accounted for on a straight-line basis over the lease term. That isn’t enough to warrant this change, however.
It might help to explain how key provisions in the proposal compare to current accounting methods. First, the model proposed by FASB includes an amortized cost-based approach to subsequent measure of both the obligation to pay rentals and the right-of-use asset, which is similar to GAAP for capital leases. It provides that the lessee should recognize an obligation to pay rentals for the longest possible term that is more likely than not to occur, taking into account the effect of any options to extend or terminate the lease. For example, in a 10-year lease with an option to extend for five years, the lessee must decide whether its liability is an obligation to pay 10 or 15 years of rentals. When determining the lease term, the lessee would consider contractual, non-contractual, business, and other factors, such as the lessee’s intentions and past practices.
The lease term may require reassessed at subsequent reporting dates if new facts or circumstances arise. The model requires that the lessee’s obligations to pay rentals include estimates of amounts payable under contingent rental arrangements, amounts payable under residual value guarantees, and expected payment under term option penalties, using a probability weighted approach.
If approved, the accounting change could have significant ramifications for public companies. They could see an impact on stock prices (either positive or negative) because financial statements – and competitors’ financial statements – would be more comparable. Or because financial statement ratios and metrics, such as return on assets and operating cash flows, would change. All issuers of financial statements might need to discuss the changes with their lenders and possibly renegotiate debt covenants.
If this all seems puzzlingly complex, that’s easy to understand. Truth be told, this proposal probably has less to do with improving accounting than it does aiding FASB in its effort to synthesize its standards with those of the International Accounting Standards Board. The unification process has picked up steam this year, which is why FASB is issuing an increasing number of exposure drafts.
In response to this proposed change, many construction industry groups are beginning to speak out. Among these groups is Equipment Leasing and Finance Association, the leading trade association for the $518 billion equipment finance sector. The association recently released a public statement saying:
“ELFA supports FASB and IASB as they seek to establish a sound, workable accounting standard that applies to the assets and liabilities arising from lease transactions. We find, however, that the lease accounting model as proposed in the long-awaited exposure draft is unduly complex and will impose a compliance burden on lessees that will not result in a significant improvement in the quality of reliability of financial information.’’
ELFA understands that the proposed change might eliminate off-balance-sheet financing, which would end one of the main advantages of leasing. That would result in a push toward shorter-term leases, or buying an asset rather than leasing it. Lessees would need to balance this consideration with potentially higher rents for shorter-term leases as well as reduced amortization periods for leasehold improvements.
Construction company professionals who may want to weigh in on the subject have until December 15 to submit comments. FASB will issue a final standard next year, but has not said when it will do so. Company owners should take time to read the FASB proposal this month, and then talk to a CPA about how they will be affected.