The Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2016-02 in February of 2016, subsequently known as, FASB Accounting Standard Codification (ASC) 842 Leases. This replaces ASC 840, which was more than 40 years old. The overarching goal of this standard is to increase comparability and transparency to financial statement readers. While this standard is not unique to nonprofits, the concept of increased transparency carries greater weight with such organizations.
Prior to ASU 2016-02, lessees classified lease agreements as either capital or operating leases. Lease obligations (liabilities) and the related assets were only recognized for capital leases. Lease arrangements considered to be operating leases resulted in a lessee not recognizing the asset and associated lease liability on the face of the statements. This left readers of financial statements lacking valuable information regarding a nonprofit organization’s true operating costs and required further analysis of footnote disclosures to ascertain information of that nature. It was, quite literally, a blind spot. ASU 2016-02 aims to reduce that blind spot by bringing all leases directly onto the face of a nonprofit organization’s financial statements.
Identification of a Lease
Under ASC 842, the definition of a lease has been modified. A contract is or contains a lease if the contract conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration. To qualify as a lease, the following criteria must be present:
- The agreement must include an identified asset
- The lessee must receive substantially all of the economic benefit of the asset
- The lessee must have the right to direct or control the use of the asset
Leases less than 12 months fall outside of the scope of ASC 842 and the related expense should be recognized on a straight-line basis over the life of the lease. Additional scope exceptions to this standard include the following:
- Leases of inventory or construction in progress
- Leases of intangible assets
- Lease of biological assets
- Leases to explore or use natural resources
Accounting for Leases Under ASC 842
The core principle of ASC 842 is that a lessee should recognize the assets and liabilities that arise from leases. As per the FASB, all leases create an asset and a liability in accordance with FASB Concepts Statement No. 6, Elements of Financial Statements. Upon entering into a lease agreement, the lessee will recognize a right of use asset and related liability on the statement of financial position.
The lease liability is equal to the present value of the remaining lease payments, discounted using the rate implicit in the lease (or the lessee’s incremental borrowing rate if an implicit rate is not present in the lease agreement). Note that the new standard indicates that only consideration of cash or other assets be included in the determination of total lease liability. Fair rental value of below market rent or free rent should NOT be included in the calculation of lease liability. Assigning value to the right of use asset shall consist of the following:
- Amount of lease liability
- Any lease payments made prior to the commencement date, minus any lease incentives received
- Any initial direct costs incurred by the lessee
Initial direct costs are those associated with negotiating a lease agreement and may include sales commissions, legal fees, document preparation costs and other costs directly related to the lease agreement that would have otherwise not been incurred. It is reasonable that the amount booked as the right of use asset does not equal the lease liability due to indirect costs.
Over the life of the lease, the lessee must amortize the right of use asset as well as recognize interest expense. The statement of activities implications under this new principle are based on the classification of the lease. Finance leases are recognized in a manner similar to what would have historically been a capital lease. Cash payments reduce the lease liability and result in interest expense being incurred. Operating lease expense is recorded on a straight-line basis over the lease term.
The new standard also requires NFPs to disclose additional information surrounding lease arrangements to help readers understand the amount, timing and uncertainty of cash flows related to leases. Lease disclosures must also illustrate both qualitative and quantitative elements, including information about variable lease payments and renewal option periods.
When a lease is terminated, there should not be any remaining right of use asset or lease liability. Remaining amounts should be recognized on the statement of activities as a gain or loss, as applicable.
ASC 842-10-30-1 states that a lessee should consider all relevant renewal options present in the agreement when determining the term of the lease. Only renewal options that are reasonably certain that the lessee will exercise the option should be included in the determination of the lease term.
Lessor Accounting for Leases
Lessor accounting under ASC 842 remains unchanged from ASC 840 in all material respects. However, lessor accounting was reviewed in conjunction with the FASBs development of ASC 606 Revenue from Contacts with Customers. The enhancements to lessor accounting principles are intended to align with the lessee accounting model as well as the updated revenue recognition guidance.
As previously noted, ASC 842 was finalized in 2016 but has yet to become effective. Numerous reasons triggered the FASB to delay effective dates, most recently including the COVID-19 pandemic. ASC 842 will be effective for nonprofits with annual reporting periods beginning after December 15, 2021. Early application is permitted.
The Effect on Nonprofit Organizations
Nonprofit organizations, by their nature, require an enhanced level of transparency with regards to financial reporting. Under ASC 842 financial statement readers will no longer need to analyze footnotes to ascertain cash flow implications of operating leases as these transactions are being brought directly to the face of the financial statements. Additional consequences of ASC 842 include effects on debt covenants, compensation agreements or other financial metrics important to a nonprofit organization’s accounting framework. Organizations are encouraged to evaluate the impacts of this standard early (like now!).
For more information or to find out if this FASB update impacts your organization, contact firstname.lastname@example.org
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