The updated lease accounting standard, released back in 2016, is finally taking effect this year for all organizations that haven’t already adopted it. You might be surprised at how many “leases” you have under the Financial Accounting Standards Board’s (FASB) Accounting Standards Update (ASU) 2016-02, Leases (Topic 842) — whether for real estate, vehicles, machinery or equipment. The changes are likely to complicate your accounting and financial reporting.
Lease Accounting Standard: Then and now
Under previous rules, leases were classified as either capital (or finance) or operating, with different accounting treatments for each. Capital leases — for example, the lease on a piece of equipment for most of its useful life — were reported as assets and liabilities on a nonprofit’s statement of financial position. Operating leases, such as a lease for office space, were recognized on financial statements as a rent expense and disclosure item.
ASU 2016-02 directs lessees to recognize assets and liabilities for all leases for terms of more than 12 months. The classification as capital or operating is relevant only when determining how to recognize, measure and present the expenses and cash flows related to a lease. The lease accounting standard also requires additional disclosures about leases, including information on variable payments and options to renew or terminate.
A lease is defined as a contract, or part of a contract, that conveys the right to control the use of identified “property, plant or equipment” for a period of time in exchange for consideration. You have control over the use if you have both the right to:
- Receive substantially all of the economic benefits from using the leased asset, and
- Direct the use of the asset.
The reference to “part of a contract” is critical. So-called embedded leases might be lurking in agreements that don’t appear to be leases on their face, such as technology, advertising or transportation contracts.
In such cases, the updated lease accounting standard requires organizations to separate lease components from non-lease components. The part of the payment attributable to non-lease components is excluded from the measurement of lease assets and liabilities.
Businesses that adhere to Generally Accepted Accounting Principles (GAAP) likely will need to adopt some new processes and procedures to satisfy the requirements in the lease accounting standard. For example, you’ll need to ensure you collect the requisite data on new leases. While smaller organizations with few leases may be able to track the information via spreadsheet, nonprofits with multiple leases may consider purchasing leasing software to assist with the accounting.
Also consider how the changes will affect your stakeholders, starting with your board and audit committee. The rule may significantly increase your assets and liabilities, potentially creating alarm. Think about preparing additional financial statements that allow stakeholders to see how this year and previous years compare with each other under the old standard — in other words, help them see that things haven’t changed as much as it might initially appear.
The financial statement changes also could affect financial ratios tied to debt covenants. Your lenders might benefit from seeing the comparison of results under the old and updated standard.
The updated lease accounting standard could have ramifications for businesses that rent out space or other assets. For example, it includes provisions designed to align lessors’ accounting with the lease accounting model and current revenue recognition rules. Lessors may need to recognize certain lease payments as deposit liabilities if the collectability of lease payments is uncertain.
In addition, lessors generally must separate non-lease components that transfer a good or service to the lessor from the lease components. Nonlease components could include utilities or common area maintenance.
Picking the discount rate
When reporting unpaid lease obligations as a liability, a lessee organization must select a discount rate to reduce payments to their present value. ASU 2016-02 requires lessees to use the rate implicit in the lease, if readily determinable. If not, they generally need to use their incremental borrowing rate (IBR), which can be difficult to ascertain.
You can elect to use a risk-free rate instead of the IBR. Moreover, FASB ASU 2021-09, Leases (Topic 842): Discount Rate for Lessees That Are Not Public Business Entities, allows you to elect the risk-free rate by asset class, rather than applying it to all leases.
The risk-free rate often will be less than the IBR, meaning it may produce higher amounts for the lease asset and liability. So you might, for example, elect the risk-free rate for an asset class with numerous low-dollar leases (such as equipment) and apply the IBR to an asset class with a few high-dollar leases (such as real estate).
Implement the Lease Accounting Standard Now
The effective date for the lease accounting standard was pushed back due to COVID-19, but businesses can’t afford to drag their feet now. Contact us for help achieving and maintaining compliance.