How a Recently Effective Accounting Standard May Influence Lease vs. Buy Decisions in the Construction Business

Deciding whether and when to lease or buy equipment is a basic part of financial management in the construction business. Leasing heavy equipment often makes more sense when convenience and cash flow are top priorities. Leasing also helps mitigate the risk of obsolescence and allows companies to adapt to changes in technology and shifting priorities. Buying equipment, even though it involves high upfront capital expenditures, can mean more flexibility and control over project demands.

A recently effective accounting standard, ASC 842, which was adopted for private companies in 2022, may prompt companies to make different decisions based on the way lease liabilities affect their bottom line.

The Impact on Financial Statements and Business Valuations

Under the previous accounting standard, ASC 840, operating leases had no balance sheet impact. ASC 842 significantly changes the way companies report lease transactions in their financial statements.

Adjusted earnings may change based on the classification of leases and directly affect earnings before interest, taxes, depreciation and amortization (EBITDA) as well as net income. Both leasing and purchasing require the recognition of Right of Use (ROU) assets and lease liabilities.

Business valuations may also be affected. When buying assets, expenses are allocated to interest and depreciation below the EBITDA line. With leases, the weight of including some of these charges in EBITDA can be substantial for construction companies and may result in significant valuation swings.

Under today’s accounting requirements, equipment ownership may boost the valuation for construction companies as the business benefits from depreciation and interest add-backs to EBITDA. This becomes especially significant for companies facing debt covenants with specific EBITDA requirements.

Is Leasing More Attractive?

These shifts, in light of ASC 842, have significantly affected companies that engage in operating leases with estimated changes adding some $2 trillion of lease liabilities to S&P 500 balance sheets. The lease liability is calculated as the present value of the future lease payments discounted using the rate implicit in the lease or the company’s incremental borrowing rate (IBR).

With these new considerations, construction companies may find leasing more attractive due to lower IBRs, particularly in the current environment of rising interest rates.

In addition, ASU 2021-09 gives private companies the option to use the risk-free rate for determining lease classification and measurement under certain conditions. A benefit of using this rate could result in a lower amount of liabilities and interest expense.

How Has ASC 842 Affected Your Company?

While leasing may present cash flow benefits, tax advantages and maintenance relief, the implementation of ASC 842 adds layers of complexity to the lease vs. buy decision. Financial considerations, accounting implications and the impact on debt covenants demand meticulous evaluation. Weaver’s advisory, tax and audit professionals can help with financial calculations and reporting required under ASC 842. Contact us for more information.

Authored by Alex Hill.

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