The New Lease Accounting Standard Deadline is Fast Approaching. Is Your Nonprofit Ready?
UPDATE: On October 16, 2019, the Financial Accounting Standards Board (FASB) voted to delay the effective date for three accounting standards, including the lease accounting standard. This standard applies to both nonprofit organizations and private companies. Full details here.
Nonprofits will see their leases in a whole new light as they begin implementing the Financial Accounting Standards Board’s (FASB’s) new lease reporting standards. As was revealed in early 2016, the FASB will soon require almost all entities, both for-profit and nonprofit, to start recording leases on their balance sheets and statements of financial position. Under current lease accounting standards, nonprofits do not record operating leases on their statements of financial position at all, but merely record “lease expenses” on their statements of activities when they make their monthly payments. We want to walk through the basics of this new requirement and discuss how it will affect you and your organization in the future.
What Is Changing?
The FASB updated the lease reporting standards to improve clarity about organizations’ lease agreements. When operating leases are only recorded on the statement of activities, investors and stakeholders are not able to easily assess an organization’s future lease obligations. These operating lease obligations may comprise a large portion of the organization’s financial commitments, so omitting them does not provide a complete picture. The new standard addresses this problem by requiring lessees (and lessors) to record all significant leases on their statements of financial position.
Under the new accounting standard, a lease will be categorized as one of the following:
A finance lease is a long-term lease of an asset. The lease term will typically be for the asset’s entire useful life, and at the end of the lease term, the title may even pass to the lessee. Accounting for these types of leases (which were previously known as “capital leases”) will not change under the new standard. Consistent with existing requirements, leases will be presented on the statement of financial position as lease assets and lease liabilities, and lease payments will be reflected on the statement of activities.
An operating lease is a lease of an asset that will be upgraded regularly. Frequently used property like copy machines and company cars are typically leased for just a few years at a time, and then replaced with a new model under a new lease agreement. Reporting operating leases will be different under the new accounting standard. Instead of only being reflected on the statement of activities when a monthly lease payment is made, the value of the asset will be recorded on the statement of financial position – just like finance leases are. The statement of financial position will reflect (1) an asset that represents the entity’s right to use the property for the lease term, and (2) a lease liability for the remainder of the lease payments.
Leases that extend less than 12 months in duration do not need to be reported on the statement of financial position at all unless the intent is for the lease to be renewed each year. In this instance, the short-term lease will be reclassified as an operating or finance lease and recorded on the statement of financial position.
When nonprofits implement this new accounting standard, they can expect a few things to change:
Financial statements will look different.
Nonprofits will need to add two additional line items to their statements of financial position: an asset and a liability to reflect their operating leases. Net assets will not change, but the nonprofit’s total asset and total liability balances will both increase.
Debt may need to be renegotiated.
Because total liability balances will increase, nonprofits will want to confirm they are not in violation of their debt covenants. They may be in default status if their debt-to-net worth ratio creeps above a certain percentage. Some banks will understand that the change is attributed to a new reporting requirement, but others may not be willing to adjust their criteria.
Business processes will need to be reviewed.
Organizations will need to revise their business and accounting processes to absorb these new changes. They may need different software to keep better track of their leased equipment, or they may need a new employee to help them during the transition.
Nonprofits’ annual reports for fiscal years beginning after December 15, 2019 (and interim reports for fiscal years beginning after December 15, 2020) are required to conform to the new standard. This means that 6/30 year-end nonprofits must comply with the new standard during their 2020/2021 fiscal year.
Although the effective date is quickly approaching, nonprofits (and other non-publicly traded entities) may be in luck; the FASB may delay the new standard’s effective date by an additional 12 months. In an Exposure Draft issued on August 15, 2019, the Board proposed that all new accounting standard changes adopt a rule of thumb: that private entities should have two years beyond public company effective dates to implement new major accounting standards. If this proposal is passed, the lease accounting effective dates would be pushed from the 2020/2021 fiscal year to the 2021/2022 fiscal year. The FASB accepted feedback on this proposal through September 16th, after which time they will make their final decision. Klatzkin will continue to monitor and report on related developments.
Don’t Stop Now
Whether or not this provision passes, we recommend that you put your implementation plan into place now if you haven’t already. If your leasing activity is anything more than inconsequential, your financial statements will change substantially, and you will need to completely overhaul your reporting protocols to account for them accurately going forward. If you need help understanding these new changes, contact a Klatzkin advisor today.