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Are Your Leases Ready to Be Audited?

Remember that New Year’s accounting resolution to implement the new lease accounting guidance for your nonprofit organization? Well, there’s still time to get that done before the end of 2022!

WHY Do I Need to Record Leases in My Books?

The Financial Accounting Standards Board issued this new standard to better align US and international accounting standards. Maybe more importantly, the standard offers guidelines for recording and reporting an organization’s assets and liabilities to improve consistency and comparability between years and between entities.

Under previous lease accounting guidance, an organization that owned its facility would report in its statement of financial position the depreciated cost of the facility and the unpaid balance of the mortgage, and would report in its statement of activities interest expense on that mortgage. By comparison, an organization that rented its facility only reported rent expense on its statement of activities. 

Even if the terms of the facility lease were similar to a mortgage in terms of length and financial commitment, the leasing organization only had to disclose the terms in the notes to  the financial statements. The statements of financial position and statements of activities of the two organizations were inherently not comparable. ASC 842 seeks to eliminate that disparity.

[Related: Internal Control Spot Checks]

WHAT Leases Need to Be Recorded?

In general, you must record any property, plant or equipment leases that expire in more than one year. Consistent with principles-based accounting, materiality does apply. There are, of course, some exceptions identified in ASC 842; contact your accountant or refer to guidance provided by the FASB or AICPA.

WHEN Should These Leases Be Recorded?

For most nonprofit organizations, the standard is effective for fiscal years beginning after December 15, 2021, which means just about all organizations should have implemented the standard by now. In reality, many organizations may have delayed implementation; after all, the FASB deferred the effective date of this standard for several years. 

Sorry, folks. No more official delays. 

The process for implementing this standard should be like the process used to implement the revenue recognition standard a couple years ago. First, gather all your leases and evaluate whether you should recognize each in your books. 

If the lease commenced prior to the beginning of your current annual accounting period, you should record that lease effective the first day of the current year. If it is a new lease, recognize it on the date the leased asset is available for use.

HOW Do I Determine What Gets Recorded?

This is where things get exciting! Well, it gets exciting if you like accounting. Now we get to play with numbers and learn some new accounting terms.

Initial Measurement

There are four key pieces of information you’ll need to record these leases: lease term, lease payments, lease concessions (rent holidays, tenant improvement allowances, etc.), and a discount rate.

The first step is to determine what the statement of financial position needs to record. Remember that an organization that owns its facility records the depreciated asset and the unpaid mortgage liability. Under the new standard, an organization that leases its facility will now record a Right of Use (ROU) asset and a lease liability, making the financial statements of the two entities more comparable.

We’ll walk through a basic overview of implementation in this article, but understand that there are a variety of factors that may add some kinks to the process. 

We’ll start with determining the lease liability; for that we’ll need the total lease payments and the elected discount rate. Calculating the total lease payments is simple enough; add up the total of lease payments, taking into consideration any rent holidays. The elected discount rate requires a little more effort.

[Related: Nonprofit Bookkeepers vs. Nonprofit Accountants: Who to Hire]

Some leases may include a stated rate, but that is not common. There is a rate implicit in every lease, but determining that rate is challenging. So, what are the other options for determining the discount rate? Nonprofits can use their incremental borrowing rate – interest rate paid by the organization on similar debt – effective at the lease commencement date. If the nonprofit does not have any debt, another option is to use the risk-free rate for an instrument with a term similar to the term of the lease. 

For example, the discount rate for a five-year equipment lease could be set at the risk-free rate for a 5-year T-bill on the date of lease commencement. 

Now that we have that data, we determine the lease liability by calculating the present value of the total lease payments over the term of the lease using the elected discount rate. Build an amortization table that reduces liability over the term of the lease; we’ll need that for later. 

Now that we have the lease liability, we can calculate the ROU asset. The math is easier here: initial lease liability plus any payments made on or before commencement plus initial direct costs less lease incentives received equals the Right of Use asset. 

Done, right? Not quite. 

Given the initial measurement of the ROU asset, it is likely there will be differences between the asset and the related liability. To balance that journal entry, the causes of that difference need to be picked up. Any lease incentives will need to be amortized over the term of the lease. We’ll pick up an unamortized lease incentive asset equal to the total incentives. Direct costs will be picked up as incurred (debit ROU asset, credit cash). GAAP still requires recognition of lease expense on a straight-line basis, so we get to do the deferred rent calculation and pick up that liability. Finally, grab that lease liability amortization schedule and add columns to calculate straight-line rent, deferred rent, and unamortized lease incentives.

Subsequent Transactions

Now that the hard work is done, paying rent each month is as easy as pulling the journal entry from the amortization schedule. All the elements should reduce towards $0 each month.

[Related: How to Select an Auditor]

WHAT Else Do I Need to Know About Lease Accounting Guidance?

Lease terms vary based on lessor requirements, lessee criteria, incentives, treatment of common area expenses and more. Accordingly, these factors will influence the initial measurement of the ROU asset and lease liability, as well as the entries required to pay the lease. Do the research or consult your accountant if your leases include complex elements.

One result of the standard is a grossed-up statement of financial position. Assets and liabilities will be higher, and it may not be a net-zero effect. Be sure to talk to your lenders about the impact of ASC 842 on any debt covenants.

Keep good notes as you work through the process and draft a lease accounting policy for your organization. Make sure it is compatible with your existing internal control structure and that the policy contains controls. Be sure to present it to your appropriate governing bodies for input and approval. Finally, prepare to discuss the process with your auditors.

WHO Do I Ask For Help with Lease Accounting Guidance? 

There are many resources available to help implement ASC 842 if you don’t have the expertise on staff. Commercial enterprises will charge you for their consulting and software services. There may be accountants on your governing bodies that can help with the process at no cost. You can also contact your auditor who can point you in the right direction, but with limited involvement, of course, to maintain independence. 

As with any business decision, perform a good cost-benefit analysis before you buy. Take into consideration the volume of leasing transactions you typically conduct and the materiality of those transactions.

Connect with Jacobson Jarvis Today

Jacobson Jarvis has over 30 years of experience in providing accounting expertise to nonprofits and charity organizations just like yours.

From lease accounting guidance to internal controls, we offer a wide range of consulting services, as well as audit guidance and tax specialization

Contact us today to learn more. We’d love to work with you!

About the Author:

Craig Mayers, MAcc, CPA, CGMA
Senior Audit Manager

Craig has been in public accounting since 2006. He has provided services for a variety of industries, but serving nonprofit organizations is what brings him the most satisfaction. Craig is passionate about helping nonprofits gather and interpret their financial information so they can continue to meet their objectives. You can find Craig teaching college accounting courses and volunteering with the AICPA, the WSCPA and in the community.

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