The Financial Accounting Standards Board (FASB) has released new regulatory updates for lease accounting. Accounting Standards Update 2016-02 Leases represents a complete overhaul of the accounting rules for leases and will impact the way nonprofits account for leases on everything from office space to the office copier.
Currently, operating leases are considered to be off-balance-sheet, and nonprofits are only required to disclose them in the footnotes of their financial statements. Moving forward, your nonprofit will need to recognize operating leases on your balance sheet.
Why the change? FASB’s stated goal is to increase transparency and comparability among organizations. Previous lease accounting was criticized for not providing financial statement users with a faithful representation of leasing transactions.
How It Works Now
Under the current approach to lease accounting, leases are classified as either operating leases or capital leases.
With an operating lease, such as those for office space and vehicles, you are only paying a fee for temporary use of an item. Thus, they are not recorded on your balance sheet. With a capital lease, such as those for office equipment, you are in effect purchasing a capital asset. This type of lease is recorded on your balance sheet as a debt and related lease asset.
How It Will Work Moving Forward
The new lease accounting rules still require classification of leases as either finance or operating. The key difference is that lease assets and liabilities from operating leases will now be reflected on your balance sheet.
This means recognizing both an asset (representing the right to use the leased asset) and a liability (representing the obligation to pay the rent, calculated at the present value of the expected lease payments).
Understanding “Right of Use”
The concept of “right of use” is the core principle behind the accounting update. The basic concept is that both an operating lease and a finance lease contract give you the right to control the use of identified assets (property, equipment, office space) for a period of time. By creating a “right of use,” the lease contract creates an asset that needs to be reflected on the balance sheet. Additionally, the liability for future payments needs to be recognized.
Operating leases will be reported as a straight-line expense, and finance leases will reflect a front-loaded expense pattern.
Bits and Pieces
Additional things you’ll need to know under the accounting change include:
Effective date – For nonpublic companies (including nonprofits), the effective date is for fiscal years beginning after December 15, 2019 (fiscal year 2020 for December 31 year-end entities).
Grandfathering – There will be no “grandfathering” of existing leases. Once the new standard becomes effective, you’ll need to apply the new guidance to all existing lease agreements, not just those entered into after the effective date.
Short-term leases – You are not required to recognize assets and liabilities for leases of 12 months or less.
Intangible assets – You are not required to account for leases of intangible assets, such as licenses of internal-use software.
Renewal terms – Renewal terms are not included in the initial lease measurement unless it is “reasonably certain” the renewal options will be exercised.
Finance leases – Moving forward, finance leases will be capitalized at the risk-free rate (i.e., interest rates on treasury securities). The current accounting rules require you to track down the implicit rate in a lease—and if that’s not available, determine the incremental borrowing rate.
Disclosures – The new rules require qualitative disclosures along with specific quantitative disclosures, including a discussion of lease expense amounts as well as any significant judgments and assumptions about the leases. According to FASB, the idea is to enable financial statement users to assess the amount, timing and uncertainty of cash flows arising from leases.
Action Steps
Take steps now to get ready for the new lease accounting standards.
Armanino’s lease accounting specialists can explain the changes and lay out the steps you should take to prepare for regulatory compliance. Please contact your local Armanino nonprofit expert with any questions about this new, and significant, accounting standard.
