Earlier this year, the Financial Accounting Standards Board (FASB) issued a revised lease accounting standard. The new standard – Accounting Standards Update (ASU) No. 2016-02, “Leases (Topic 842)” – may impact many contractors that lease vehicles, equipment or buildings.

FASB standards apply to all contractors that must maintain financial statements that comply with generally accepted accounting principles (GAAP). GAAP-compliant statements are required by lenders and bonding companies for most privately held contractors and public contractors, as well. The new financial reporting and accounting procedures are likely to affect some of the financial ratios stipulated in various types of loan covenants and surety agreements. Now is a good time to proactively plan in order to try to pre-empt potential problems.

The Changes

Under existing accounting rules, operating leases generally do not appear on a company’s balance sheet. This applies to all types of operating leases, including leases for vehicles, equipment, office machines, and office or warehouse space.

Under the new standard, you will be required to record the present value of the scheduled lease payments as a liability on the balance sheet. This liability would be balanced by recording the “right-of-use” value of the property or equipment as an asset. (There could be minor additional adjustments to the asset to reflect broker’s fees or other direct costs.)

The new standard allows an exception for short-term leases or those lasting less than 12 months that do not include a renewal option the lessee is “reasonably certain” to exercise. This means even short-term leases must appear on the balance sheet if they include extension options that meet these criteria.

The Impact

The most significant effect of the new lease accounting rules for most contractors will be their impact on commonly used financial metrics, particularly the working capital ratio and the debt-to-equity ratio. Many loan agreements and surety contracts require contractors to maintain these ratios at specified levels and to submit financial statements that demonstrate compliance. As a result, many contractors could find themselves out of compliance because of lease obligations that drive up their current liabilities and total liabilities.

Operating Leases v. Finance Leases

The existing standard makes a distinction between operating leases and capital leases, such as those that offer a bargain purchase option at the end of the lease. Because capital leases are generally regarded as a form of financing, they are already recorded on the balance sheet as a liability.

Under the new standard, this distinction is less important, since all leases over 12 months in duration will now appear on the balance sheet. The interest and amortization expenses for the two types of leases are handled differently, but these distinctions will not affect most contractors significantly. The new standard also changes the terminology somewhat, referring to finance leases instead of capital leases.

Other Related Matters

Many leases in the construction industry involve company owners who purchase property and lease it back to their businesses. The new lease accounting rules apply to such related party leases the same as third party leases, based on the “legally enforceable” terms of the lease agreement.

How to Prepare

For publicly traded companies, the new lease accounting standard will take effect for reporting periods beginning after Dec. 15, 2018. For privately held companies, the new standard goes into effect for reporting periods beginning after Dec. 15, 2019. Companies can begin applying the standard sooner if they choose.

Although the effective date seems to be far in the future, implementation of this standard will generally be overlapping with the implementation of FASB’s new revenue recognition standard. Because of this, companies should begin responding to this new standard sooner rather than later through the following methodology:

1. Understand the new standard and monitor changes in interpretation that are naturally expected to occur.

2. Create a cross-functional implementation team (e.g. finance, legal, operations, human resources, I.T.) and plan to implement the new standard.

3. Identify and communicate with stakeholders regarding the potential impacts to financial metrics, covenants, and other agreements (e.g. compensation).

4. Populate lease data and establish required judgments, estimates and accounting policy elections.

How HBK Can Help

HBK’s multidisciplinary team of accounting, tax and valuation professionals are available to assist in assessing how the new leases standard will impact you. Existing attest clients will receive training services on the technical aspects of the new standard as well as advice on project management and planning. Further assessment and implementation services are available to non-attest clients.

The IRS has moved back the deadlines for filing tax returns and making payments for taxpayers affected by either Hurricane Harvey or Irma who have either an original or extended due date falling on or after the onset date of the disaster. Affected taxpayers will have until January 31, 2018 to file most tax returns, including individual, estate, trust, partnership, C corporation, and S corporation income tax returns; estate, gift, and generation-skipping transfer tax returns; and employment and certain excise tax returns; or to make tax payments, including estimated tax payments.

Affected Taxpayers

Affected taxpayers include:

• Any individual whose principal residence, and any business entity whose principal place of business, is located in the counties designated as disaster areas
• Any individual who is a relief worker assisting in a covered disaster area, regardless of whether he is affiliated with recognized government or philanthropic organizations
• Any individual whose principal residence, and any business entity whose principal place of business, is not located in a covered disaster area, but whose records necessary to meet a filing or payment deadline are maintained in a covered disaster area
• Any estate or trust that has tax records necessary to meet a filing or payment deadline in a covered disaster area, and
• Any spouse of an affected taxpayer, solely with regard to a joint return of the husband and wife.

IRS is offering filing and payment relief to any area designated by the Federal Emergency Management Agency (FEMA) as qualifying for Individual Assistance. Currently the affected areas include:

• In U.S. Virgin Islands: The islands of St. John and St. Thomas.
• In Puerto Rico: The municipalities of Culebra, Vieques, Canóvanas and Loíza.
• In Florida: All 67 counties.
• In Georgia: All 159 counties.
• In Texas: Aransas, Austin, Bastrop, Bee, Brazoria, Calhoun, Chambers, Colorado, DeWitt, Fayette, Fort Bend, Galveston, Goliad, Gonzales, Hardin, Harris, Jackson, Jasper, Jefferson, Karnes, Kleberg, Lavaca, Lee, Liberty, Matagorda, Montgomery, Newton, Nueces, Orange, Polk, Refugio, Sabine, San Jacinto, San Patricio, Tyler, Victoria, Walker, Waller and Wharton counties.

How to Apply for Relief

The IRS automatically identifies taxpayers located in the covered disaster area and applies automatic filing and payment relief. But if you are an affected taxpayer and you receive a late filing or late payment penalty notice from the IRS that has an original or extended filing, payment or deposit due date that falls within the postponement period, call the telephone number on the notice to have the IRS remove the penalty. Affected taxpayers who reside or have a business located outside the covered disaster area must call the IRS disaster hotline at 866-562-5227 to request this tax relief.

Over the last five years, the number of IRS examinations of individual income tax returns has declined across all income levels. This is due in large part to the IRS having suffered from budget cuts. The chart below shows the percentage of tax returns audited from 2011 to 2015.

Most IRS examinations of tax returns are correspondence audits rather than face-to-face audits. The IRS matches income amounts, which includes information reported by payers of income, to the amounts reported on personal income tax returns and sends notices with proposed adjustments to the tax bill if the amounts do not match up. Information reported to the IRS by payers of income includes wages, interest, dividends, stock sales, and real estate sales proceeds, among other sources of income. It’s important to point out that the IRS is not always correct, so those who receive a notice from the IRS on a proposed tax increase should never automatically agree.

In addition to examinations that result from income matching, the IRS has a secret scoring system it uses to identify tax returns to audit, called the Discriminant Inventory Function (DIF) system. The higher the DIF score, the more likely a tax return will be audited. DIF scoring rates certain items in a tax return higher, such as home office deductions and hobby losses. The IRS also measures average deductions for each income level and uses that information in their DIF scoring. Data gathered from related party tax returns that were subject to examination is also used to determine if a tax return should be audited.

The IRS is planning to increase its auditing efforts, especially for higher income taxpayers. IRS has not tipped its hand on what they will specifically be looking for, but we expect the list to at the very least include the following:

• Large charitable deductions. There are specific documentation requirements for deducting charitable contributions, especially for noncash donations.
• Claiming losses on business ventures. Investors must pass several tests in order to be allowed to deduct a loss from a business venture. Some activities may not rise to the level of a business, such as raising horses, racing cars and farming, which may be characterized as hobby losses.
• Energy credits. There have been several tax incentives allowed for alternate energy sources, which have specific requirements.
• Offshore assets and banking. There are significant penalties for failing to report offshore financial assets. This has been a focus of the IRS for several years now.
• Micro-Captive insurance companies. The tax law allows taxpayers to form their own insurance companies to manage their risks. The IRS has identified specific profiles of abusive captives and now requires additional information reporting for these companies.
• Related party transactions. Transactions between related family members, owners and their companies are subject to certain limitations and reasonableness.

I always harken back to the quotes of the famous Tax Court Judge Learned Hand (yes that is his real name). He said:

“Any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one’s taxes.”

“Over and over again courts have said that there is nothing sinister in so arranging one’s affairs as to keep taxes as low as possible. Everybody does so, rich or poor; and all do right, for nobody owes any public duty to pay more than the law demands: taxes are enforced exactions, not voluntary contributions. To demand more in the name of morals is mere cant.”

The tax law allows many advantageous tax planning strategies. The IRS should not undo or challenge a tax strategy simply because it results in a lower tax liability. At the same time, we have a responsibility to comply with the tax laws and maintain the required documentation to support our tax filings. We can help you be prepared to manage and plan to take full advantage of tax planning opportunities the law allows. We will also have your back should the IRS comes calling. After all, it is your money.