The joint project between the FASB and the International Accounting Standards Board to enhance financial reporting standards for leasing activities has been underway since 2006. With implementation dates postponed several times, most recently due to the COVID-19 pandemic, it sometimes seemed as if the standard would never take effect.

But the time is now for organizations to adopt the reporting practices they will need to comply with the new lease standard, as it is now effective for public not-for-profit (NFP) organizations and will become effective for all other entities for fiscal years beginning after December 15, 2021.

Background

In February 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2016-02, Leases (codified as ASC 842). The main objectives are to increase comparability and transparency among entities, to reduce off-balance-sheet risk and to reflect the substance of the leasing transactions in the financial statements. Currently, the operating leases are disclosed in the financial statements, however, disclosure alone does not capture the full substance of the transaction.

ASC 842 will require organizations that lease assets, referred to as lessees, to recognize on the balance sheet (or statement of financial position) the present value of the assets and liabilities for the rights and obligations created by those leases. How a lease will be measured and reported in an organization’s financial statements will depend on whether the lease is classified as a finance or operating lease. Prior to the implementation of ASC 842, only leases that met certain criteria to be classified as capital leases were recognized on the balance sheet. Under Topic 842, operating leases with terms of more than 12 months will be recognized as assets and liabilities.

Effective Dates

As a result of COVID-19, the FASB provided a deferral option for the lease standard for one year, including for those public NFP entities that had not yet issued financial statements (or made available for issuance) reflecting the adoption. Therefore, ASC 842 is now effective for public NFP entities for fiscal years beginning after December 15, 2019 (i.e., calendar 2020 or fiscal 2021), and all other entities for fiscal years beginning after December 15, 2021 (i.e., calendar 2022 or fiscal 2023).

Transition Guidance

During 2018, the FASB issued ASU 2018-11 that provided some targeted improvements to the lease standard, providing additional transition guidance. Entities may elect not to recast the comparative periods presented when adopting ASC 842. This allows entities to report comparative periods for financial reporting and not to restate the comparative periods in transition. For example, if an entity adopted the lease standard in the 2020 fiscal year, it can opt to not restate 2019 fiscal year balance sheet information and still present fully comparative financial statements.

Given that several years have passed since ASC 842 was issued, most preparers and users of NFP financial statements should have some awareness of the changes that will be occurring. However, with public NFP entities required to adopt the new lease guidance for fiscal years ended December 31, 2020, it is important for NFP organizations to prioritize the time and resources that will be required to effectively implement the lease standard. In addition, NFP organizations will need to ensure that policies and procedures have been established to ensure that lease reporting and accounting is integrated into the finance function going forward.

The FASB has acknowledged that organizations will incur additional costs in implementing ASC 842. However, the FASB believes that the benefits of the leasing standard, in the form of more relevant and transparent financial statements, justify the costs that will be required of financial statement preparers.

For most NFPs, the primary costs associated with implementing the new standard will be the additional time and effort required of staff (both operational and administrative) in educating employees about the requirements of the new standard and gathering the necessary information to properly implement the standard. While larger NFPs may have a larger volume of leasing transactions or more complicated leases, such organizations generally would have more available resources to implement the new standard, whether that be in the form of greater staffing and experience in their accounting function or the ability to outsource some of the required work to third parties with specialized knowledge and experience in this area.

NFPs will need to gain a thorough understanding of ASC 842 and take necessary steps to ensure an efficient transition to the new lease reporting model. Key items for NFPs to consider include the following:

1. Identifying Leases Accurately: Identifying a lease transaction is one of the most critical areas to consider in appropriately adopting ASC 842. For a transaction to be considered a lease, there needs to be an identified asset and the right to control the asset. An identified asset should be explicitly identified in the agreement (example: serial number, building address). An entity controls an identified asset when the entity has both the right to direct its use and the right to obtain substantially all economic benefits from it use. 
2. Policies and Procedures: New policies and procedures will need to be implemented to ensure that all leases required to be accounted for under the new model are appropriately identified and are communicated to the NFP’s finance department for tracking and recording. This will be more critical for larger NFPs with decentralized operations and/or multiple locations to ensure that the population of leases being maintained by finance is complete. Short-term leases that have terms of 12 months or less and do not include a purchase option that the lessee is reasonably certain to exercise are excluded from the standard. In such situations, the entities can make a formal policy election and include in the financial statements that the entity does not recognize short-term leases on the balance sheet. 
3. Choosing the Discount Rate: The estimated discount rate can have a substantial effect on the reported amount of lease liabilities and right-of-use assets. Using a higher estimated discount rate would result in lower recognized lease liabilities and right-of-use assets. As a result, this may lead to a lower current ratio or higher debt-to-equity ratio. If determinable, lessees are required to use the rate implicit in the lease. However, if the implicit rate is not determinable lessees may use an incremental borrowing rate which is the rate of interest that the lessee would have to pay to borrow on a collateralized basis over a similar term an amount equal to the lease payments in a similar economic environment. The estimated borrowing rate could be determined using the rate on the lessee’s debt, rate quoted by a lender, or the borrowing rate of entities like the lessee.
   
   The FASB has permitted organizations that are not public business entities to make an accounting policy election to use a risk-free rate (i.e., U.S. Treasury rate) as the discount rate for all leases. Risk-free rates would generally be lower than an organization’s estimated borrowing rate, particularly in the current low interest rate environment, which would result in higher recognized lease liabilities and right-of-use assets. If elected, this risk-free rate is required to be applied to all of an organization’s leases. However, at its April 14, 2021, board meeting the FASB added a project to its technical agenda to amend the accounting policy election for lessees that are not public business entities to use a risk-free rate as the discount rate. On June 16, 2021, a proposed ASU was issued that would allow lessees that are not public business entities to make the risk-free rate accounting policy election by class of underlying asset, rather than at the organization-wide level. Comments on this proposed ASU are requested by July 16, 2021. 
4. Lease Capitalization Policy: Topic 842 indicates that organizations “will likely be able to adopt reasonable capitalization thresholds below which lease assets and lease liabilities are not recognized.” Therefore, NFPs will need to establish a threshold for evaluating leases for recognition as a right-of-use asset and liability similar to the threshold that has been established for capitalizing purchases of property and equipment. NFPs should give thought to the effect on both assets and liabilities when determining a reasonable threshold.
5. Calculation of the Lease Liability: Once an NFP has gathered the information necessary for its leases it will need to determine the most efficient manner to calculate the lease assets and liabilities. For example, NFPs with only a few simple leases might utilize Microsoft Excel to do the calculations (i.e., the display approach) whereby NFPs with more complicated leasing arrangements might deem it more efficient to utilize lease accounting software to perform the calculations and prepare the resulting journal entries. In addition, NFPs will need to decide whether the lease journal entries will be done annually or will be done more frequently and incorporated into the NFP’s periodic closing and internal financial reporting processes. While an NFP’s independent auditor may assist the NFP with the implementation of the new lease standard, the responsibility for the financial statements remains with the NFP. In order to ensure there is no impairment of independence, NFPs are required to designate a competent management-level individual with suitable skills, knowledge and experience to oversee any services provided by the independent auditor in assisting with the preparation of the NFP’s financial statements. This includes evaluating the adequacy and results of the services and accepting responsibility for the results of the services. 
6. Pro Forma Financial Statement Disclosures: NFP’s should compile the necessary information needed for adequate financial statement disclosures. Such disclosures are both qualitative and quantitative including the following:
   • Nature of the lease
   • Leases that have not yet commenced but that create significant rights and obligations
   • Significant assumptions and judgments used
   • Main terms and conditions
   • Operating lease cost
   • Short-term lease cost
   • Sublease income
7. Impact on Bank Covenants: As the lease standard has been on the horizon for several years, most NFPs should be aware of any impact the recognition of the right-to-use assets and related liabilities would have on its debt covenants. If they have not already done so, NFPs should communicate with their lenders to discuss the practical impact of adopting the new lease standard and whether any adjustments or modifications to debt covenants are necessary.  
8. Educate the Stakeholders: It is also important for NFPs to educate their stakeholders about the new lease standard and what the practical impact will be on the financial statements. This includes board members, donors and governmental funding sources, members, etc. 

ASC 842 accounting requirements are substantial and will require, in many cases, significant investments of time and effort. NFPs should develop an implementation plan and coordinate with their external auditors for the adoption of the new lease standard. Using the right software to calculate lease obligations can assist with the journal entries and disclosure preparation.