The new lease accounting standard, ASC 842, took effect January 1, 2022. Most not-for-profits and private companies are partway into the first year of implementation and dealing with many issues for the first time. Questions like how to identify a lease, managing new balance sheet implications, and what to do with complex leases or a large lease portfolio are probably still coming up in Finance Department meetings. Some confusion in the first year of implementation for such a big accounting change is to be expected.
Identifying a Lease
Some contracts are leases under the new standard. Not-for-profits (NFPs) can start by identifying which of these contracts constitutes a lease.
A lease contract will have all these elements:
- An identified asset that cannot be substituted for something else.
- Either implicit or explicit identification counts.
- The organization has the exclusive right to control the asset. This is called right of control or right of use.
- The asset is conveyed for a specific time period.
- This can be a specified lease term or the asset’s useful life.
- The organization retains most of the economic benefit of using the asset.
In some cases, a separate and distinct part of a larger asset could be considered a lease contract; however, a volume portion of another asset wouldn’t count. For example, a single floor of a building could qualify but a percentage of volume of a large storage container wouldn’t. Embedded leases, where a contract has both lease and non-lease components, will need to be identified.
Maintenance agreements, service plans, and supply contracts are not leases under ASC 842.
Once a lease is identified, it will either be classified as an operating or a finance lease, formerly known as a capital lease.
Operating and Finance Leases Under ASC 842
There are two main types of leases, and both must be recorded on the balance sheet: operating and finance leases.
Finance leases need to meet one out of five requirements.
- The asset’s ownership is transferred to the lessee at the end of the lease term.
- There is a purchase option in the lease that the lessee is reasonably certain to use at some point.
- The lease term covers most of the asset’s useful life.
- Lease payments are equal to or more than the asset’s value.
- The asset is specialized in nature and has value only or mostly to the lessee.
NFPs will need to exercise reasonable judgment on what constitutes remaining useful life and present value, since ASC 842 removed the previously used bright line tests to determine eligibility.
Finance leases will frontload expenses on the balance sheet whereas operating leases are recorded in a straight-line expense measurement.
For their part, lessors won’t see as many changes as lessees; they will continue to classify leases as either sales, direct financing, or operating. That’s not to say there aren’t modifications to the accounting. For example, lessors will now classify leases at their commencement rather than inception.
NFPs can also make an election not to recognize short-term leases on the balance sheet.
A lease contract is short-term if it’s 12 months or less and doesn’t include the right to purchase the underlying asset. In addition, lease extensions must be considered in determining whether or not a lease is short-term. Policy elections must be disclosed in financial statements.
For more information on navigating the new lease accounting process, visit this resource on the PBMares website and look for the downloaded guide.
Special Considerations for Not-for-Profit Organizations
NFPs have other factors at play beyond private companies.
There is the question of real estate: some organizations rent their space while others own the building and/or related property. Leasing can be more cost effective but now that ASC 842 is underway, the various lease components will require deeper layers of lease accounting.
Then there is the issue of below-market value property, plant, or equipment leases. Many NFPs may have more favorable lease terms than their for-profit counterparts. Below-market rent contracts under ASC 842 should only record actual lease payments made excluding the fair market value. The donated rent, or additional value, would be recorded as a contribution at its fair value rate in the period in which the contribution is received. Related expenses would also be recorded on the income statement in the same period the property or assets are used.
Finally, what to do with donated assets or space? The new standard defines a lease as: a contract, or part of a contract, that conveys the right of control and the use of identified property, plant, and equipment (an identified asset) for a period of time in exchange for consideration.
Since no consideration is exchanged for the use of the space, donated space does not meet the definition of a lease under ASC 842.
Accounting Changes related to contributed non-financial assets (Accounting Standards Update 2020-07—Not-for-Profit Entities (Topic 958): Presentation and Disclosures by Not-for-Profit Entities for Contributed Nonfinancial Assets
Considerations for donated space and other assets don’t end there. ASU 2020-07 covers the presentation for contributed non-financial assets, like in-kind gifts or donated non-cash assets. That can include property and equipment, land, services, the use of assets, and materials, as common examples.
Moving forward, NFPs will need to present contributed non-financial assets as a separate line item in the statement of activities. This should be separate and distinct from cash contributions or other donated financial assets.
An extra disclosure is also required on the statement of activities. NFPs should disclose the nature of nonfinancial assets, separated by category.
For each category of non-financial assets, the NFP must disclose:
- Qualitative information about whether the contributed non-financial assets were either monetized or utilized during the reporting period.
- If they were utilized, the NFP must provide a description of the programs or other activities in which those assets were used.
- The NFP’s policy (if any) about monetizing rather than utilizing contributed non-financial assets.
- A description of any donor-imposed restrictions associated with the contributed non-financial assets.
- The valuation techniques and inputs used to arrive at a fair value measure, in accordance with the requirements in FASB ASC Topic 820, Fair Value Measurement, at initial recognition.
- The principal market (or most advantageous market) used to arrive at a fair value measure if it is a market in which the recipient NFP is prohibited by a donor-imposed restriction from selling or using the contributed nonfinancial assets.
FASB is requiring the standard to be applied retrospectively. The amendments take effect for annual reporting periods beginning after June 15, 2021, and interim periods within annual reporting periods beginning after June 15, 2022. Early adoption is permitted.
Considering the cross-over with new lease accounting guidance, many NFPs may find it simpler to adopt this new standard at the same time.
For ASC 842 implementation, a good place to start is listing all contracts and agreements as of the implementation date. Mark those already identified as a lease, contracts that are clearly service arrangements, and which ones will need further review. For those contracts, apply the five-part test to determine if the lease is a finance or operating lease and whether there are embedded lease components.
NFPs that rent their office space or other assets should pay close attention to deferred, prepaid, and free rent as well as rent holidays, variable rent increases, renewal periods, and lease incentives.
It’s probable that internal controls and accounting policies will need to change as ASC 842 is rolled out.
Now may be an excellent time to consider upgrading the organization’s accounting software. NFPs with a large volume of leases will have trouble implementing ASC 842 manually with spreadsheets, though it can be done. A streamlined approach to new accounting changes can be achieved through a combination of planning, preparation, and cooperation among departments and advisors.
For questions about ASC 842 or new in-kind accounting rules, contact Hillary Dorzweiler, CPA, Director in PBMares’ Not-for-Profit practice, or Shawn Middleton, CPA, Partner in PBMares’ Audit & Assurance group.