Now that financial statements reflect ASC 842, construction companies need to understand the potential effects on bonding and business so they can plan accordingly.

Last year, private companies were focused on identifying and categorizing leases to ensure they were accurately reflected on financial statements to comply with the lease accounting standard ASC 842 (which replaced ASC 840). Financial statements for year-end December 31, 2022 and beyond reflect the new standard. (Public companies adopted the standard for reporting periods starting January 1, 2019.)

Impact on Bonding

To work on certain projects, you may need a bond from a surety company to guarantee the terms of a contract will be fulfilled, as well as a certain bonding capacity (the maximum amount of coverage a surety company will provide). Sometimes a project owner may not require bonding, but instead uses bonding capacity as a prerequisite for being able to bid on a project.

Having a high bonding capacity shows a project owner that your business can meet its contractual obligations. It also allows you to bid on larger projects, enhancing your business’ ability to grow. There are even times that bonding capacity can mean the difference between winning and losing a contract.

ASC 842 impacts bonding and bonding capacity because financial performance is one of the primary factors a surety company will review when determining whether to issue a bond and for how much (they may also look at your work portfolio, experiences, references, business practices, and more). ASC 842 requirements can significantly impact financial performance reporting, potentially increasing challenges in obtaining bonding approvals or leading to higher bonding costs.

Impact on Financial Statements

Before ASC 842 took effect, operating leases simply had to be disclosed in a footnote on financial statements. With ASC 842, all leases – financing and operating – are recognized as assets and liabilities on the balance sheet. There is one exception: short-term leases, defined as leases with terms of 12 months or less at the lease commencement date, are not included.

The change enhances transparency and enables a more apples-to-apples comparison of companies’ debt related to leases and overall finances. At the same time, it can also impact key metrics on your financial statement and ultimately your ability to secure bonds (or loans), your bonding capacity, and more.

For example:

• Debt-Service Coverage Ratio (DSCR) measures a company’s available cash flow to pay current debt obligations (principal and interest). As a result of ASC 842, DSCR may decrease, putting your ability to service existing debts into question and impacting perception about your business’ financial stability.

• Working capital shows a company’s ability to pay current liabilities with current assets. It’s calculated by subtracting liabilities from assets. ASC 842 reporting requirements may result in a decrease in working capital, impacting perception about your business’ health and operational efficiency.
• Debt to equity ratio (D/E) compares total debt to shareholder equity, revealing how much your business relies on borrowed funds to operate. A lower D/E is favored because it means your business has a lower risk of defaulting on a loan. However, a ratio that’s too low may be interpreted to mean a business isn’t using debt effectively for expansion. ASC 842 can increase liabilities and ultimately D/E, signaling potential issues with your company’s financial leverage.

The changes resulting from ASC 842 can affect a number of other metrics as well (i.e., interest coverage, return on assets, debt coverage ratio, and more).

Managing the Impact

Nobody likes surprises, especially when it comes to finances. Considering the broad impact of ASC 842, no doubt your stakeholders – including banks, surety companies and others – are aware of the new disclosure requirements for leases. Proactively communicating the impact ASC 842 has on your financial statement may help manage perceptions. (If you need assistance, you may want to consider speaking with your accountant.)

This may also be a good time to re-evaluate your leasing strategy. Is leasing still a better option than ownership? Is there any benefit to moving to shorter-term leases (i.e., 12 months or less) to minimize potential impact on financial reporting?

Finally, consider the longer-term. Based on how ASC 842 impacts your balance sheet and financial statement, are there business or operating changes you should consider to bring financial metrics back to where you want them to be?