The new lease accounting standard will be one of the most impactful pronouncements in recent history and promises to have far-reaching implications on most organizations. The key to implementation will be to get an early start and have clear communications with involved parties. The transition to recognizing operating leases on the face of the statement of financial position will have a significant impact on key performance indicators and loan covenants so preparation for that impact will be crucial.
The Financial Accounting Standards Board’s (FASB’s) new standard on accounting for leases is set to take effect January 1, 2020 for not-for-profit organizations with calendar year ends. Accounting Standards Codification (ASC) Topic 842, Leases, changes the accounting treatment for leases substantially. The industry expects this standard to have far-reaching implications.
While ASC 842 retains the two-model approach to classifying leases as operating or finance, most leases under the new standard will now be recorded on the statement of financial position. For example, current “off-balance sheet” leasing activities, otherwise known as operating leases, will be required to be reflected on the statement of financial position. This is so that users of the financial statements can more readily and accurately understand the rights and obligations associated with these transactions.
Finance leases will be accounted for in substantially the same manner as capital leases are accounted for under existing Generally Accepted Accounting Principles (GAAP). Operating leases will continue to be accounted for on the statement of activities, functional expenses, and cash flows in a manner consistent with operating leases under existing GAAP. However, under the new lease standard, operating leases will also be recorded on the face of the statement of financial position. Consistent with current treatment, operating leases will continue to require lease expense to be recognized on a straight-line bases over the lease term, while finance leases require the lessee to recognize interest expense and amortization expense.
In many respects, the new lease standard can be thought of as moving the operating lease obligations from the footnotes to the face of the statement of financial position; basically a change in display. The significant change will result in the recording of a liability based on the present value of future lease payments with an offsetting entry to recognize a right-of-use asset. The present value rate will be based on the stated rate within the lease agreement or, absent an explicit rate, the lessee’s incremental borrowing rate.
Monitoring debt covenants is an additional element worthy of consideration. As lease obligations move onto the statement of financial position for a not-for-profit organization, they have the potential to negatively affect covenants with lenders and key performance indicator expectations will also need to be reevaluated in light of the impact of the growth that will take place on the statement of financial position. Organizations should be proactive in reaching out to their lenders for any debt covenants that may potentially be violated once the lease standard is implemented.