After multiple delays, the Financial Accounting Standards Board’s (FASB) new lease accounting guidance is in effect for nonprofit organizations with fiscal years beginning after December 15, 2021 (Calendar year 2022 for organizations with a December 31, fiscal year end and the fiscal year beginning in 2022 for most other entities). The FASB’s stated objective when initially announcing Accounting Standards Update (ASU) No. 2016-02, Leases (Topic 842) was to improve transparency and accountability between organizations regardless of whether the assets used by an organization were purchased or leased. To do this, the guidance calls for most leases to be recognized as lease assets and lease liabilities on the statement of net position, and to disclose key information about leasing transactions.
Accounting Standards Codification (ASC) 842 defines leases as contracts, or portions of contracts, granting control of an identifiable asset for a specific period of time in exchange for compensation. Control of an asset is demonstrated when a business entity is able to obtain substantially all of the economic benefit from the asset’s use and direct its use throughout the period of the contract.
ASC 842 applies to most leases and subleases, but exceptions do exist. Leases of intangible assets (including intangible IT arrangements), leases for natural resources or biological assets, leases of inventory and leases of assets under construction are not included within the scope of the ASU. However, both leases previously treated as operating leases and those previously treated as capital leases are included, as are sale-leaseback transactions and leveraged lease arrangements.
Similar to the previous standards, the new lease accounting standard uses a two-model approach for lessees; each lease is classified as either a finance lease or an operating lease. Finance lease is a new term and the term capital lease, previously used to define some lease agreements, is no longer in use. While similar, the criteria in which a finance lease is defined is not the same as the criteria used in the past for capital leases, so it is more than just a terminology change.
Topic 842 requires lessees to recognize both the assets and the liabilities arising from their leases. The lease liability is measured as the present value of lease payments. The lease asset is generally equal to the lease liability, but should be adjusted for certain items like prepaid rent and lease incentives.
Under the new rules, both financing and operating leases will be reflected on the statement of financial position. FASB defines the lease asset as a right-of-use asset, or (ROU asset), and represents the lessee’s right to use the underlying asset. The lease liability represents the lessee’s financial obligation over the lease term. When measuring the assets and liabilities, both the lessee and the lessor should also include “reasonably certain” lease renewals beyond the current lease term and “reasonably certain” asset purchase options, based on the criteria in the ASC.
Leases which have a term less than 12 months after accounting for all renewal options are permitted to not recognize a ROU asset and lease liability. If they choose not to recognize, they should instead recognize lease expense on a straight-line basis over the life of the lease.
Existing capital leases have been provided transitional relief and will not require adjustment or remeasurement upon transition. However, the financial statements should refer to them as finance leases.
Financial statement recognition of the leases is similar for both operating and finance leases, but there are few key differences. Operating leases should recognize a single lease cost allocated over the lease term, generally on a straight-line basis, and should be recognized within operating activities on the statement of cash flows. Finance leases should recognize the interest component of the lease separate from the rest of the repayments. The interest portion of the repayment should be considered an operating activity for the statement of cash flows, while the rest of the payment should be treated as a financing activity.
Lessor accounting practices remain largely unchanged from ASC 840 to 842, except that the “leveraged lease” type of lease has been eliminated.
Interested in knowing more about ASC 842? Contact us at Barbacane Thornton & Company, LLP. We have a team of professionals excited to be your auditors and trusted advisors.