Accounting Standards Update No. 2016-02: New Lease Accounting Standard in Effect
It has been more than two years since Accounting Standards Update No. 2016-02 (ASC 842) became effective for private companies and nonprofit organizations for fiscal years beginning after December 15, 2021. However, some nonprofits are still adjusting to this major accounting change in the treatment of leases.
The new lease accounting standard affects all organizations—including nonprofits—that lease real estate, vehicles, equipment, or other assets for more than one year. Previously, operating leases were considered “off” balance sheet, which meant they only had to be disclosed in the financial statement footnotes. This made it hard to identify future debts that could reflect significant financial liabilities.
Lease obligations longer than 12 months must now be reported on the balance sheet as a right-of-use (ROU) asset and lease liability. The intention is to improve transparency and provide a more accurate measure of the contractual obligations that underlie leases.
More Consistent Representation
With the new lease accounting standard, financial statement users benefit from a more consistent representation of lease obligations. It’s now easier for users to understand the amount, timing, and uncertainty of cash flows related to leases.
All operating leases must now be recorded as an asset and a liability on the balance sheet. The ROU asset must be amortized over the life of the lease while an offsetting liability for the present value of the lease payments must be recorded. This represents the obligation to pay the lease.
According to the right-to-use concept, an operating or finance lease contract gives the lessee the right to control the use of an asset for a certain time period. This right creates an asset that must be reflected on the balance sheet, along with a corresponding recognized liability.
Note that short-term leases of 12 months or less and leases for intangible assets (such as computer software) are not subject to the new lease accounting standard.
Important Points
Here are a few things to keep in mind as you continue adjusting to the new lease accounting standard:
- The standard creates a new lease definition: “A contract or part of a contract that conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration.”
- The standard also creates a new lease term: the noncancellable period during which a lessee has the right to use an underlying asset. This term should be based on the period during which the contract is enforceable.
- Because operating leases now create a lease liability and ROU asset on the balance sheet, it’s important to review all service agreements and contracts to see if they contain an embedded lease. If so, the lease must be accounted for using the new standard.
Impact of the New Standards
ASC 842 is significantly impacting organizations with long-term leases. For starters, the additional debt and leverage added to the balance sheet is affecting lenders’ financial ratios and metrics. This could affect debt covenants so it’s important to talk to lenders about the potential impact.
Also, because off-balance-sheet financing under U.S. GAAP was one of the main benefits of leasing, the curtailment of this type of accounting structure is altering the lease vs. buy decision for organizations. In some instances, asset purchases could be more attractive than they were in the past.
Eliminate Confusion
It’s important to educate lenders, board members, donors, and other stakeholders who use your financial statements about how ASC 842 has changed the representation of leases on your statements. This will help eliminate any confusion or unpleasant surprises.
Contact our Nonprofit Group if you have questions about the new lease accounting standard.
