Government contractors should be sensitive to the changes that are happening with leases as these changes will increase the complexity of their financial statements. If the proposed standard passes the way it is drafted right now then all leases, other than short-term leases, would be recognized on the balance sheet and presentation of the lease-related expenses on the income statement would depend on the type of lease.
This change will impact financial ratios and may include an interest expense component that was not prevalent before.
Financial ratios such as debt to equity, working capital, and interest coverage ratios may be negatively impacted, whereas other performance measures such as EBITDA and cash flow from operations could be positively impacted. The likely result of these changes will be the modification of financial covenants in the contractor’s loan agreements with financial institutions. There is a requirement for continuous re-measurement of these leases which will also increase the volatility of the financial ratios. New measurement metrics will have to be established to properly assess an entity’s financial position.
The expense recognition pattern for many property leases would be consistent with current accounting practices, but many equipment leases that are currently accounted for as operating leases would be treated differently under the proposed standard, effectively treating them all as capital leases. In order to satisfy this, a present value calculation is performed, which, by definition, designates a portion of the lease payments as interest expense. The FAR currently states that interest costs for capital leases are an unallowable expense.
For several years, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) have been deliberating over current proposed changes to lease accounting rules which could have a significant impact on government contractors. Capitalizing a right of use asset with a corresponding lease liability on the balance sheet will change the entire presentation of the financial statements of an entity.
This proposed standard is still in a draft phase with no date yet established for its adoption. Contractors need to be aware of the potential impacts of the standard when making business decisions for leases that might carry forward into years after which it will be effective.
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