Lease accounting urgency ramps up for not-for-profits

By Ken Tysiac

Joe Purvis, CPA, has taken a different tone with his not-for-profit clients this year with respect to lease accounting.

For the past several years, each time Purvis's not-for-profit clients have asked him whether implementation of FASB's lease accounting standard would be required before the end of the year, there has been some sort of delay that kept adoption far out on the horizon.

The standard was issued in February 2016, and while public companies already have adopted it, numerous delays related to the COVID-19 pandemic and other factors have allowed most not-for-profits (as well as private companies) to wait to implement the standard.

Now, the waiting is over.

"The conversations this year have been 'Yes, this is effective now. You need to understand and implement the standard to get the books in order,'" said Purvis, a principal at Clark Nuber PS.

FASB ASC Topic 842, Leases, requires lessees to recognize on the balance sheet the assets and liabilities associated with their lease contracts with terms of more than 12 months. For a small not-for-profit whose only lease is the office space it rents, the implementation of the standard may not be difficult.

It's more challenging for organizations that lease a fleet of vehicles or other heavy equipment, or have numerous offices, each with a different lease for its copier. And careful attention must be paid to the definition of a lease, as contracts for IT data management/cloud services, transportation, and even advertising might have a lease "embedded" in the deal.

Various entities have already been required to implement the standard. These include public business entities, employee benefit plans that file financial statements with the SEC, and not-for-profits that have issued or are conduit bond obligors for securities that are traded, listed, or quoted on an exchange or over-the-counter market.

For all other organizations (including most not-for-profits), the standard takes effect for fiscal years beginning after Dec. 15, 2021, and interim periods within fiscal years beginning after Dec. 15, 2022. So implementation should be underway.

"In today's environment, it's very easy to let this sit until December if you're a calendar year end," said Paul Preziotti, CPA, a partner with Johnson Lambert and a member of the AICPA Not-for-Profit Advisory Council. "I would say don't do that. Maybe make it a summer project."

Early adopter saw big changes

Amy West, CPA, CGMA, didn't wait to perform the implementation as executive vice president and CFO of AHRC of New York City, which supports people with developmental disabilities. She knew the standard would have a significant impact on her organization.

"We do have approximately 300 operating leases," said West, a member of the AICPA Not-for-Profit Advisory Council. "Real property, a fleet of vehicles, and copy machines were the three major components of our leases."

AHRC has a June 30 fiscal year end, and 2019 marked the first time its financial statements reflected the adoption of FASB's new lease accounting standard. West hired an outside consultant to help with the adoption.

"Given the impact it was going to have on our financials as well as the number of leases, it was helpful to retain outside help," West said.

In addition, AHRC is now looking for leasing software to help the finance department generate the journal entries and the footnotes, as well as to help the organization manage the approximately 150 properties it maintains throughout New York City.

These might not be the right decisions for every not-for-profit. Some organizations with a small number of leases are finding they can handle the implementation on their own and that they can continue performing their lease accounting using spreadsheets rather than installing a new technological system for lease accounting.

"For some organizations it may be simple," Preziotti said. "You may have only one material lease, and it could be your lease for office space, and that could be it. In that case, not to minimize it, but it's a little easier of a lift versus an organization that, let's say you're in the situation where you have multiple leases for operating space."

Before making those decisions, though, it's important for not-for-profit finance leaders to make sure they understand exactly how many leases they have according to FASB's new definition of a lease. FASB defines a lease as a contract or part of a contract that conveys the right to control the use of identified property, plant, or equipment for a period of time in exchange for consideration. Control over the use of the identified asset means that the customer has both (1) the right to obtain substantially all of the economic benefits from the use of the asset and (2) the right to direct the use of the asset.

The "part of a contract" requirement means that leases may be hidden in agreements that aren't ordinarily thought of as leases. These "embedded leases" can be found in larger service contracts such as technology agreements, transportation agreements, and advertising contracts. Not-for-profits may choose to analyze all their contracts for the possibility that they might have leases embedded within.

This review of contracts for possible embedded leases should involve multiple people throughout the organization, Purvis said. The finance team, people in IT roles, and anyone who performs procurement in the organization are among those who should examine contracts.

"Identify those key individuals within the organization that are making significant procurements so you can ask them about what they're purchasing and determine if more analysis needs to be done on [whether] a lease is there," Purvis said.

It also may be important to talk with decision-makers, up to and including the COO or CEO. Preziotti cites the example of a lease with a renewal or purchase option. The likelihood that those options would be exercised will affect the accounting and may be a decision that's made at the highest level of the organization.

"For certain things like that when you're making judgments, it might be appropriate [for finance] to involve other parties at the not-for-profit," Preziotti said.

Discount rate decision

Once leases have been located and the relevant data has been extracted from them, lessees need to choose a discount rate.

The discount rate helps determine the present value of the lease payment that is not yet paid. Under Topic 842, lessees are required to use the rate implicit in the lease, if that's readily determinable. If the implicit rate is not readily determinable, lessees are required to use the incremental borrowing rate; but nonpublic business entities can elect to use a risk-free rate by asset class as described in FASB Accounting Standards Update No. 2021-09, Leases (Topic 842): Discount Rate for Lessees That Are Not Public Business Entities. The risk-free rate should be used for a period comparable to the lease term.

The rate implicit in the lease often is not determinable, and the incremental borrowing rate can be difficult to calculate or estimate. The risk-free rate, which can be used by class of underlying lease asset by not-for-profits and private companies, is the borrowing rate for a zero-coupon U.S. Treasury instrument for the same period as the lease.

The risk-free rate is likely to be lower than the incremental borrowing rate, so the risk-free rate is likely to result in higher values for the lease asset and lease liability. That tradeoff was worth it for AHRC, West said, as it used the risk-free rate in one of the most difficult decisions of the process.

"We had a lot of discussion about what rates to use or what rate to use," she said. "We just found a lot of comfort in being able to go online and find a published rate."

Either way, AHRC was going to have a large addition to its balance sheet as a result of the lease accounting implementation. As it turned out, about $130 million was added both to the organization's assets and liabilities, with an insignificant negative change to the net asset balance. This required some explanation to the board and audit committee.

West's team prepared additional financials that enabled comparison to the previous year so the members of the governance bodies could gauge how the organization performed from year to year.

Preziotti said it's not unusual for a not-for-profit to appear to be much larger after adoption than it did before, because a 10- or 15-year office lease can be a very large right-to-use asset and lease liability to add to the financial statements.

"For me, it's more of an optics thing to think about what the financial statements look like post-adoption," he said.

Keeping lenders informed

The lease accounting standard was issued so long ago that some of Purvis's not-for-profit clients anticipated its impact when they negotiated agreements with their lenders.

These covenants state that for purposes of the debt agreements, financials would continue to be considered as if the previous lease accounting standard, ASC Topic 840, were in effect. Some organizations also have signed debt agreements with "frozen GAAP clauses," which state that future changes in GAAP will not have an effect on the financial ratios in the debt agreement.

"Understand how it's going to impact key financial ratios before it's time to do your financial reporting so that you can start conversations with your bankers early to determine if there needs to be some modification to how the ratios in the covenant are calculated," Purvis said.

AHRC had a frozen GAAP clause in its debt covenant, which is up for renewal in May. So the organization has provided the lender with a bridge schedule showing its financial statements without the impact of adopting the lease accounting pronouncement.

Once not-for-profits get the standard implemented, they also need to have processes and controls in place to make sure all new contracts are analyzed for lease components and account for them accordingly. The complexity and sophistication of those controls may vary depending on the size of the not-for-profit, Purvis said.

"My smaller not-for-profit clients could probably go around and ask a few people to figure out what their big new contracts are," he said. "At the bigger organizations that have large procurement systems, it's probably more of a system-based implementation of, 'OK, does this contract contain a lease?' Figure out how best to work in controls in your existing control structure that identify where those [leases] are."

The good thing about implementing the standard is that some not-for-profits are finding that their compliance exercise delivers operational improvements. Back in 2016, FASB Vice Chair Jim Kroeker encouraged companies whose lease processes were decentralized to consider centralizing them to improve efficiency or cost-effectiveness.

AHRC has found that having its real property information in one place enables the organization to analyze it in a better way.

"A byproduct of this adoption and having new cloud-based leasing software in place will allow us to better manage our real property," West said. "I think it will allow us to evaluate our real property footprint and get a real understanding. Having it all in one place is very powerful."

— To comment on this article or to suggest an idea for another article, contact Ken Tysiac at Kenneth.Tysiac@aicpa-cima.com.

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