The Financial Accounting Standards Board (FASB) has issued Accounting Standards Update (ASU) 2016-02, Leases (Topic 842), its final standard on lease accounting. The guidance takes effect in 2018/2019, affecting all construction contractors’ assets and liabilities. Contractors who have significant fleet leasing activity will feel the change most. The most significant change requires lessees to recognize right-of-use assets and lease liabilities for all leases other than short-term leases. This applies to most leases currently accounted for as operating leases under legacy U.S. generally accepted accounting principles (GAAP).

Initial Accounting – The new guidance requires lessees to classify leases as either finance or operating leases using criteria similar to those in legacy GAAP and are required to recognize right-of-use assets and lease liabilities for all leases not considered short-term leases. A short-term lease is one in which the lease term is 12 months or less, or there is not an option to purchase the underlying asset that the lessee is reasonably certain to exercise. For short-term leases, lessees may elect an accounting policy by class of underlying assets under which the right-of-use assets and lease liabilities are not recognized, and payments are generally recognized over the lease term on a straight-line basis.

For leases to which the election is not applied, the initial measurement of the liability is recorded by the lessee discounting the payments not yet paid over the lease term using the rate implicit in the lease, if that rate is readily determinable. If that rate is not readily determinable, the incremental borrowing rate is used. Lessees that are not public business entities may elect an accounting policy to use the risk-free rate for a period comparable to the lease term. If elected, this policy applies to all leases. For the initial measurement of the right-of-use asset, the lessee starts with the amount of the lease liability and adjusts it for any lease payments made to the lessor (net of any lease incentives received by the lessee) on or before the lease’s commencement date and any initial direct costs incurred.

Subsequent Accounting – How lease costs are recognized in the income statement depends on whether the lease is classified as a financing or operating lease. When there are no variable lease payments or impairment issues, the periodic costs recognized by the lessee for a financing lease are generally higher earlier in the term given the unwinding of the discount on the liability using the effective interest rate method and the amortization of the right-of use asset over the shorter of the useful life of the asset or the lease term generally on a straight-line basis. Conversely, for an operating lease, the costs are generally recognized over the term on a straight-line basis or a more appropriate systematic and rational basis.

Presentation – For right-of-use assets and lease liabilities under the new guidance, lessees should either present the assets and liabilities for financing leases and operating leases as separate line items on the balance sheet, or disclose them separately in notes to the financial statements. Classification of lease expense on the income statement under the new lease guidance depends on its classification of the lease. If it is classified as a financing lease, classification of the portion of the lease expense related to the amortization of the right-of use asset and the portion of the expense related to interest on the liability should be consistent with how the lessee classifies similar expenses on its income statement. If the lease is classified as an operating lease, the expense should be included in the lessee’s income from continuing operations.

Debt Covenants – Companies that are lessees and traditionally have entered into operating leases could be significantly affected by the requirement to recognize assets and liabilities on their balance sheets for all but short-term leases. Consult your financial professional on the full impact of the new guidance.