Much-anticipated updated accounting standards are out on how to treat leases. They will affect all organizations that lease assets such as real estate, vehicles and equipment.
Accounting for your leases
Currently, the proper treatment of a lease depends on whether it’s a capital lease or an operating lease. Capital leases (for example, a lease of equipment with a $1 purchase option at the end) are reported as assets and liabilities on balance sheets. Operating leases (for instance, a lease of office space for 10 years) don’t appear on balance sheets and are recognized on financial statements only as rent expense and a disclosure item.
The Financial Accounting Standards Board (FASB) in February issued an update to the proper treatment of leases in financial statements under U.S. Generally Accepted Accounting Principles (GAAP). The new guidance is called Accounting Standards Update (ASU) No. 2016-02, Leases (Topic 842).
ASU 2016-02 requires you to recognize assets and liabilities for all leases with terms of more than 12 months. You’ll report the right to use the leased asset (for example, a building or piece of equipment) on the balance sheet as an asset and the obligation to pay rent, reduced to its present value, as a liability.
Your recognition, measurement and presentation of expenses and cash flows arising from a lease will continue to depend largely on whether it’s a finance lease (similar to a capital lease) or operating lease:
Finance leases. On the statement of activities, you’ll recognize the amortization of leased assets separately from interest on the lease liability. On the statement of cash flows, you’ll classify repayments of the principal portion of the lease liability within financing activities. Payments of interest on the lease liability and variable lease payments will be classified within operating activities on that statement.
Operating leases. You’ll recognize a single total lease cost, computed so that the cost of the lease is allocated over the lease term generally on a straight-line basis. All cash payments will be classified within operating activities on the statement of cash flows.
The new standard also requires organizations to make disclosures to help users of their financial statements better understand the amount, timing and uncertainty of cash flows related to leases. Disclosures will include information about variable lease payments and options to renew and terminate leases.
Accounting for combined contracts
Your nonprofit may enter into a contract with both lease and service components (for example, an office space lease that includes maintenance services). ASU 2016-02 dictates that organizations continue to separate the lease components from the nonlease components and provides additional guidance on how to do so.
In particular, the payment an organization makes under the contract is allocated to the lease and nonlease components on a relative standalone price basis. Payment related to nonlease components isn’t considered a lease payment, so it’s excluded from the measurement of lease assets or liabilities.
Preparing for lease negotiations
The changes to how your organization will account for leases on your financial statements also may change how you approach lease negotiations or prompt you to seek lease modifications. With specific lease terms playing a role in determining your reporting responsibilities, your priorities could change.
For instance, it might prove wise to request lower fixed rent and higher variable costs through percentage rent or common area maintenance charges. That’s because you can exclude most variable lease payments when measuring lease assets and liabilities (other than those that depend on an index or a rate set at the beginning of the lease or are, in substance, fixed payments). You might even consider buying instead of leasing, as you’ll end up with similar debt on your balance sheet as you would if you lease.
Most nonprofits will need to comply with the new standards on their financial statements for annual periods beginning after December 15, 2019, and for interim periods beginning a year later. Early adoption is permitted, and early preparation is encouraged. (See “3 steps to take now.”) If you have questions, please give us a call.
Sidebar: 3 steps to take now
With the effective date of the new accounting rules several years down the road, it might be tempting to delay preparation. That would be a mistake.
The rules will apply to prior-year comparative information that is included in your financial statements when the rules take effect. If you typically include two years of comparative information, you’ll need to be able to present the 2018 and 2019 data in a format that complies with the new rules when you include it in your 2020 financial statements.
To get started:
- Perform an inventory of your leases — you can use the inventory to determine which leases require which accounting treatment.
- Determine the effects of additional lease liabilities — you may need to contact lenders and other stakeholders if the changes will affect debt covenants or other metrics they consider.
- Make appropriate changes to accounting and financial reporting processes — adjustments to your tracking of debt covenants and month end procedures might be necessary under the new requirements.