For the first time in many years, not-for-profit (NFP) entities will be inundated with a series of new Accounting Standards Updates (ASU). These will likely require organizations to invest significant time and resources to understand and implement the required changes. For NFPs that have issued debt securities listed on an exchange, certain standards not only require expanded disclosures, but are effective one year earlier than for all other organizations.
This article series will explore expected struggles organizations may encounter when adopting each of these new standards and provide tips for successful implementation. The following table outlines the upcoming accounting pronouncements and effective dates for December 31 and June 30 year-ends.
Last month, we took an in-depth look at the expected implementation challenges of the new revenue recognition standard. This month, we’ll examine accounting for leases.
Accounting for Leases (ASU 2016-02)
This ASU’s objective is to increase transparency and comparability among organizations by recognizing rights and obligations of leasing activities as assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements to improve financial reporting. The significant changes include:
- Recognizing lease assets and lease liabilities by lessees for those leases classified as operating leases under previous generally accepted accounting principles (GAAP)
- Requiring an entity to separate the lease components from the nonlease components, e.g., maintenance services or other activities that transfer a good or service to the customer, in a contract. Although this was a requirement per previous GAAP, the ASU now provides more guidance on how to identify and separate components
- Enhancing note disclosures to include qualitative and quantitative disclosures to provide the reader with more information about the nature of the entity’s leasing activities
Challenge 1 – Identification & Classification of Existing Leases
NFPs with many operating leases may not have the resources available to gather, review and analyze existing lease arrangements and make the necessary accounting and reporting changes to adhere to the new reporting standards for existing leases.
The ASU allows the entity to apply the lease guidance at a portfolio level and elect transition reliefs called “practical expedients.” This includes the option to forgo the requirement to review existing contracts for lease arrangements and evaluate lease classification for existing leases, as well as the need to identify initial direct costs for leases that commenced before the effective date. Electing these practical expedients will allow the NFP to only consider lease agreements entered into on or after the new ASU’s implementation date.
For leases with a term of 12 months or less, a lessee is permitted to make an accounting policy election by class of underlying asset without recognizing lease assets and lease liabilities. If a lessee makes this election, it should generally recognize lease expense for such leases on a straight-line basis over the lease term.
Challenge 2 – Separation of Lease & Nonlease Components
Leases may have various components, e.g., an equipment lease that includes maintenance services, in a contract. Only the lease components must be accounted for in accordance with the ASU, with the nonlease components accounted for in accordance with other applicable topics.
The ASU provides a practical expedient for lessees as it relates to separating lease components from the nonlease components. Lessees may make an accounting policy election by class of underlying asset without separating lease components from nonlease components. If an entity makes that accounting policy election, it’s required to account for the nonlease and related lease components together as a single lease component.
Challenge 3 – New Qualitative & Quantitative Disclosures
The ASU expands the required footnote disclosure both in quantitative and qualitative requirements, and will likely take significant time to accumulate and prepare. NFPs will need to read and excerpt lease agreements to support these expanded requirements. This includes qualitative information about the nature of leases (and subleases) such as general description, basis, terms and conditions of variable lease payments, extension and termination options, residual value guarantees and restrictions and covenants, as well as leases not yet commenced that create significant rights and obligations.
The quantitative disclosures include finance lease cost (separating right-of-use amortization and interest on lease liability), operating lease cost, short-term lease cost, variable lease cost, sublease income and net gain or loss recognized from sale and leaseback transactions. Required disclosures also include amounts segregated between finance and operating leases for weighted-average remaining lease term, weighted-average discount rate and cash paid for amounts included in the measurement of lease liabilities.
Depending on its volume of leasing activities, the NFP should assign a team or team member to gain an understanding of the new disclosure requirements under the new ASU. The team or team member should then read the NFP’s leasing agreements to gather the required information and prepare pro forma disclosures for review by the NFP’s financial management team in advance of implementation. Once the note disclosure is established, the NFP should maintain all leasing information in a central location or department to help keep disclosures regularly updated as leases are amended or initiated. Also, if an NFP has a large volume of leases, it may consider using data extraction software to extract relevant data from lease documents.
Challenge 4 – Debt Covenants
Many NFPs have debt agreements and financing arrangements that require compliance with debt covenants that could be affected by the changes brought by the ASU. These covenants, if violated, could cause the NFP to be in default of the debt agreement. Typical loan covenant ratios that could be affected include debt coverage ratios, current ratios and debt-to-equity ratios.
NFPs should review existing debt agreements for a “frozen GAAP” or “semifrozen GAAP” clause. This means a change in a lessee’s financial ratios that results solely from a GAAP accounting change either doesn’t result in a debt covenant default or simply requires both parties to renegotiate in good faith.
NFPs should begin discussions with bond counsel or banks regarding how their financial information is used and what effect the new standard will have. The discussion should include existing debt covenants that may be affected as well as how the changes will affect negotiating new debt agreements.
How BKD Can Help
We encourage organizations to start assessing the effect of the new ASU now. The new lease requirements, along with implementing the other accounting changes, will likely take significant time to address. BKD can help read existing lease documents, as well as new leases your organization may be considering. We can discuss changes in reporting with you and your bank or bond counsel to help assess the effect on your bond or debt ratings and any related debt covenants. In addition, we can help navigate the process for accumulating and preparing the newly required disclosures and schedules. Please contact Amanda or your trusted BKD advisor for assistance implementing the new lease ASU and preparing the new disclosures.
Additional resources for your reference include:
Watch out for the next article in our new standard implementation series, which will cover the new contributions standard.