Lease Accounting Changes: Make Sure Three Strikes Doesn’t Mean You’re Out

Here are the Big Three impacts from new tax and accounting rules and what you need to do to stay in the game.

2019 is sure to be an exciting year for contractors. Whether this excitement is a result of “good” things or “bad” things is yet to be determined.

One thing I know is there is sure to be excitement as a result of the new tax and accounting rules, and again the result could be either good or bad. Accounting and tax issues are really something you can’t avoid, so make sure you add a big increase for professional fees for the year.

I didn’t plan on covering more tax and accounting issues this month, especially after making you read through the lease accounting review last month. But after sitting down with some contractors to review the “Big Three” in terms of lease accounting, new revenue recognition rules and the tax law, I found that adjusting your financials as a result of implementing these new rules could produce dramatic changes in both your book and tax results — to the point where comparative trend analysis will go out the window.

Contractor MDs Are Here to Help

What I planned to introduce you to this month is a new website I set up to assist contractors in solving financial, marketing, operational, legal, tax and accounting issues. In other words, it will help you deal with the Big Three plus whatever else you have on your plate that requires coaching and help with decision making. The site name is Contractor MDs and it can be found at https://contractormd.org. Take a look at it. It is a work in progress and I would like to hear from you if you have ideas that would improve the product.

All of the folks listed in the directory know your industry. You may be acquainted with some of them. Ken Hedlund, for example, has assisted me with certain topics I cover in this column, and at other times I have interviewed him to get his input on overhead allocation and other relevant topics. Ken works with contractors all over the country and has an excellent reputation.

If you care to sample our work, please listen to the podcast of a webinar we did a few weeks ago covering the new tax bill. I believe you will find it industry specific as well as informative. Pay attention to the cash basis accounting opportunity because it may make sense for a lot of you — with “may” being the key word here.

So, if you have a question or problem to address, give the appropriate expert a call or email to discuss it. If there is a subject that needs an expert other than those appearing on the list, just let me know and I will find someone for you to talk to.

Back to the Big Three

Now, let’s assume you consider yourself a good business operator. You do your planning and your homework, you take care of your customers and deliver quality products and/or services. You also keep a proper, professional set of books for both internal accounting and tax purposes, which allows you to use historical results as a guide to future planning and execution of business plans. If you are this person, I salute you and suggest you keep up the good work.

Keep in mind that your financing sources have also compiled a file on your financial situation and have a rough idea what they expect to see, which in turn gives them comfort when addressing your financing needs.

So here come the Big Three.

First of all, that solid balance sheet you possess now has considerably more assets and liabilities on it. The equity balance did not change, but both total assets and total liabilities did because you recorded your lease liabilities on your balance sheet. (See last month’s column at www.ForConstructionPros.com/21033104.)

You may say, “So what? It is a push; assets and liabilities both increased by the same amount.” But — and this is a big “but” — the equity balance did not change and your debt to equity and debt coverage ratio both indicate a weaker financial position regarding your ability to manage debt. That is Strike One.

Second, your income statements are consistent and reflect a nice upward trend demonstrating your ability to control costs, as well as get the pricing you need to get the job done. Nice going.

Now, the new revenue recognition rules hit you and you find that you are booking revenues for work prematurely according to the new rules — which means your revenues could decrease and be pushed into the following year. That’s a bad thing, yet also a good thing because your taxable income would be less, as well.

After reading these recognition rules, I imagine a lot of contractors will have adjustments to make and may even have to switch from percentage of completion accounting to completed contract accounting, or vice versa. The rules, however, only cover long-term contracts (as defined). So not only is your balance sheet in a state of flux, your income statement could be joining the party. That’s Strike Two.

To add to the confusion, you also have new, very complicated tax options to contend with. These should not be messed with, since in a lot of cases, what you believe to be the results of the changes are not accurate. For example, the C-Corp getting the 21% tax rate sounds great compared to S-Corp or flow-through entities. And switching to the cash basis of accounting for tax purposes sounds great. But each may have more “bad” results compared to the one- or two-time “good” results. That’s Strike Three.       

What Happens After Strike Three? 

So, here is how the conversation will go with your bankers if you get three strikes:

“Hi, Banker. How’s it going? Let me summarize our results for this year because things look a little strange. First, our coverage ratios really took a big hit because I capitalized our operating leases. In fact, we may have violated a covenant and will need a waiver for our auditor. In addition, we had to adjust our accounting for contracts and as a result our revenues are overstated, and consequently total revenues for the year are down 30% along with a 50% decrease in our bottom line. Do you believe this stuff? And lastly, we changed to cash basis for tax purposes, which gave us a big break this year, but not as big as it would have been if we could have continued to account for revenue as we had in the past. And by the way, I need to increase my lines for work I see coming in the next year.”

Lots of luck with this one!

The point here is you need to get this right, and get it right the first time. Work with folks who know these issues and how to deal with them and present them. If you’re working with professionals that do not have heavy expertise in the construction industry, you are asking for trouble. Need backup? Visit ContractorMD.org.

Garry Bartecki is the managing member of GB Financial Services LLP and a consultant to the Associated Equipment Distributors. He can be reached at  (708) 347-9109 or gbartecki@comcast.net.

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