Preparing for Lease Accounting Changes

Posted by Christina Bell, CPA

Delaware Nonprofit AuditsIn February of this year the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2016-02, Leases, a 485-page document that made significant changes to how leases will be accounted for by both lessees and lessors. Limited resources for administrative and accounting expertise and a focus on becoming more “program efficient” often results in nonprofit organizations struggling to implement new accounting standards. However, this change will affect accounting requirements for most nonprofit organizations. Therefore, the time is now to familiarize yourself with the changes and develop a plan for implementation.

The following is a high-level summary of the most important changes within ASU 2016-02 that will impact nonprofit lessees.

Prior to this ASU there were two primary types of leases: operating and capital. Capital leases were leases that were accounted for as if the nonprofit organization had acquired the asset by assuming a liability. The criteria for classification as a capital lease was as follows:

  • Title to the asset transferred from the lessor to the lessee at the end of the lease period.
  • The lessee could buy the asset from the lessor at the end of the lease term for a below-market price (bargain purchase option).
  • The period of the lease encompassed at least 75% of the asset’s useful life.
  • The present value of future minimum lease payments required under the lease was at least 90% of the fair value of the asset at the inception of the lease.

Capital leases resulted in the lessee having to record the asset on their balance sheet along with a corresponding liability in the amount of the present value of all future lease payments.

Operating leases were leases that did not meet the criteria of a capital lease. The lessee of an operating lease would record each lease payment as an expense. No balance sheet entry was generally required.

The goal of ASU 2016-02 is to present a more accurate representation of the rights and obligations arising from leases by requiring all lessees to recognize lease assets and lease liabilities  in the statement of financial position and improve the comparability of lessee’s financial commitments regardless of the manner they chose to finance the assets used in their programs. As such, ASU 2016-02 changes the terminology of leases and how they are to be recorded in the financial statements. Leases will now be classified as either finance or operating. The criteria to distinguish finance leases from operating leases is very similar to the criteria used to distinguish capital leases from operating leases prior to this ASU. For finance leases, a lessee is required to do the following:

  • Recognize a right-of-use asset (an asset that represents a lessee’s right to use an underlying asset for the lease term) and a lease liability, initially measured at the present value of the lease payments, in the statement of financial position
  • Recognize interest on the lease liability separately from amortization of the right-of-use asset in the statement of comprehensive income
  • Classify repayments of the principal portion of the lease liability within financing activities and payments of interest on the lease liability and variable lease payments within operating activities in the statement of cash flows.

For operating leases, a lessee is required to do the following:

  • Recognize a right-of-use asset and a lease liability, initially measured at the present value of the lease payments, in the statement of financial position
  • Recognize a single lease cost, calculated so that the cost of the lease is allocated over the lease term on a generally straight-line basis
  • Classify all cash payments within operating activities in the statement of cash flows.

ASU 2016-02 will take effect for fiscal years beginning after December 15, 2018 (for example year ending December 31, 2019 or year ending June 30, 2020 financial statements), including interim periods within those fiscal years, for the following types of organizations:

  • A public business entity
  • A not-for-profit entity that has issued, or is a conduit bond obligor for, securities that are traded, listed, or quoted on an exchange or an over-the-counter market
  • An employee benefit plan that files financial statements with the U.S. Securities and Exchange Commission

For all other organizations, the ASU will take effect for fiscal years beginning after December 15, 2019 (for example year ending December 31, 2020 or year ending June 30, 2021 financial statements), and for interim periods within fiscal years beginning after December 15, 2020. Early adoption is permitted. At the adoption date, the standard must be applied to the earliest comparative reporting period presented to provide comparable information to the financial statement reader. As such, lessees are required to recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach. The modified retrospective approach includes a number of optional practical expedients that entities may elect to apply. These practical expedients relate to the identification and classification of leases that commenced before the effective date, initial direct costs for leases that commenced before the effective date, and the ability to use hindsight in evaluating lessee options to extend or terminate a lease or to purchase the underlying asset. An entity that elects to apply the practical expedients will, in effect, continue to account for leases that commence before the effective date in accordance with previous GAAP unless the lease is modified, except that lessees are required to recognize a right-of-use asset and a lease liability for all operating leases at each reporting date based on the present value of the remaining minimum rental payments that were tracked and disclosed under previous GAAP.

Even though implementation is still years away, one of the most important things a nonprofit organization can do now is to determine how the users of their financial statements will react to these changes, including the potential increase in reported liabilities. An area that this will definitely affect is debt covenants with financial institutions. Organizations must be proactive in addressing these issues, such as requesting that liabilities created by operating leases be excluded from debt covenant calculations when negotiating new borrowing agreements or have current agreements be amended to avoid default solely due to this ASU. Additionally, organizations should also spend a few minutes with their accountants discussing how this ASU will impact their financial statements and ratios. Preparing and planning for implementation now will aid in a smooth transition at the adoption date.

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