How the New Lease Standard Affects Nonprofits

June 10, 2020

Nearly 10 years after the release of the initial exposure draft, FASB issued ASU 2016-02, Leases. The standard may have been issued, but the conversation about this re-write of legacy guidance has not slowed.

The purpose of this overhaul to existing standards was to increase comparability among organizations by recognizing an asset and a liability on the balance sheet for assets leased under operating lease arrangements. Previous standards have long been criticized for obstructing comparability by not requiring such recognition, thus allowing lessees to keep related assets and liabilities off their balance sheets.

The accounting for a finance lease will not represent a major change compared to the current accounting requirements for a capital lease, with a lessee accounting for a right-of-use asset and a lease obligation at the commencement of the lease. The most significant changes resulting from the new standard affect the accounting for operating leases.

Do You Have an Operating Lease?
A lease that meets none of these criteria is an operating lease:

  • Ownership transfers to lessee by end of lease.
  • Lessee is reasonably certain to exercise option to purchase the asset.
  • Lease term is for major part of asset’s remaining economic life.
  • Present value of lease payments is more than substantially all of the asset’s fair value.
  • Asset will have no alternative use to lessor at end of lease.

To apply the new guidance at initial measurement, lessees will first calculate the lease liability as the present value of lease payments not yet made, discounted using the rate described above. The right of use asset is the calculated lease liability, plus initial direct costs incurred by the lessee and any prepaid lease payments, less any receipt of lease incentives.

An example journal entry is as follows:
Dr. Right of Use Asset $280,000
Cr. Lease Liability $280,000

In subsequent periods, the lessee will reduce the lease liability as lease payments are made, recording the interest portion of payments (resulting from discounting) as rent expense. The right of use asset is amortized over the lease term by the difference between the straight-line lease expense and the lease liability accretion.

Example journal entries are as follows:
Dr. Rent Expense $19,088
Dr. Lease Liability 80,912
Cr. Cash $100,000
(Interest expense = $280,000 opening lease liability x 6.8172% discount rate)
Dr. Rent Expense $92,579
Cr. Right of Use Asset $92,579
(Amortization = $111,667 straight-line lease expense - $19,088 interest expense)

As you can see above, a lessee reports all activity related to an operating lease in a single expense account on its Statement of Activities. This approach results in all activity related to the operating lease being reported within the operating section of the Statement of Cash Flows. The lessee’s Statement of Financial Position would report both the Right of Use Asset and the Lease Liability.

Note that, for operating leases with a term of 12 months or less that do not contain one or more renewal options of which exercise is reasonably certain, a lessee is permitted to make an election by class of underlying asset to not recognize lease assets or liabilities. Under such election, the lessee continues to recognize lease expense on a straight-line basis over the lease term.

In addition to ASU 2016-02, “Leases,” FASB also issued ASU 2018-11 to address and respond to criticisms of unnecessary cost or complexity in the original standard.

The new ASU covers two topics of concern:

  • Comparative reporting at adoption.
  • Practical expedient to lessors for separating components of a contract.

Comparative Reporting
The original ASU required retroactive application to all periods presented. Under the new optional transition method of ASU 2018-11, an entity can apply the new standard at the adoption date and recognize a cumulative-effect adjustment to opening retained earnings in the period of adoption. Comparative periods presented in the financial statements, under this new standard, continue to be reported in accordance with current accounting principles. There is no change to related disclosure requirements.

Separating Components
The original ASU required lessors to separate non-lease components when applying the new ASU standard. Under the new transition method, lessors can adopt the practical expedient to account for all lease components as a single component if (1) the timing and pattern of transfer of the non-lease components are the same as the lease components, and (2) the lease component would be classified as an operating lease if accounted for separately. Additional disclosures are required if adopting the new ASU. For entities that have already early-adopted ASU 2016-02, the practical expedient may be elected in either the first reporting period following issuance of this ASU or at the original effective date for the entity. In addition, the practical expedient may be applied either retrospectively or prospectively. Note that a similar practical expedient for lessees was included in ASU 2016-02 as issued.

Remember that the new standard is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years, for nonprofits that have issued or are conduit bond obligors for securities that are traded, listed, or quoted on an exchange or an over-the-counter market. For all other nonprofits, the new standard is effective for fiscal years beginning after December 15, 2019, and interim periods within fiscal years beginning after December 15, 2020. Early application is permitted for all entities.

How to Apply the New Lease Standard
Application of the new standard to each operating lease may be complicated, depending on the complexity of the lease terms. It’s important to ensure it’s done correctly.

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