Accounting Challenges with Nonprofit Operating Leases

Original Publication Date: April, 2022

By Denise Wu, CPA, CGFM
HPBS, LLC

BACKGROUND

In February 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2016-02, Leases. ASU 2016-02 was intended to improve financial reporting for leases, mainly, to increase the transparency of leases and allow stakeholders to better understand the financial commitments an entity has made for leases, which used to be opaque under the former accounting model. ASU 2016-02 had far-reaching implications on how entities should report their direct financing or operating leases.1 An operating lease requires that a lessee report a Right-of-Use (ROU) asset and a lease liability, except for shortterm leases that are 12 months or less without an exercise option. The lease liability recorded must be measured at the present value on a discounted basis. Complications arose when entities attempted to implement ASU 2016-02.

One of the complicating factors was applying a discount rate to the lease. For a nonprofit lessee, the discount rate is defined as “the rate implicit in the lease unless that rate cannot be readily determined”. In that case, the lessee is required to use its incremental borrowing rate. For many non-public business entities, including nonprofits, this requirement created additional costs and challenges as most entities do not have sufficient data points to determine their implicit lease interest rate or their incremental borrowing rate2.

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1 A finance lease is a sales-type lease that transfers ownership of the asset by the end of the lease term. An
operating lease is any lease that is not a finance lease. 2 FASB defines the Incremental Borrowing Rate as the “rate of interest that a lessee would have to pay to borrow on a collateralized basis over a similar term an amount equal to the lease payments in a similar economic environment”.

In September 2020, the FASB held public roundtables to discuss lease implementation topics. During those discussions, stakeholders expressed concerns about the cost and complexity of applying ASC Topic 842, specifically regarding the determination of the discount rate used to measure a lessee’s lease liabilities and ROU assets.

After further deliberation, based on public input, in November 2021, FASB issued “Accounting Standards Update 2021-09—Leases (Topic 842): Discount Rate for Lessees That Are Not Public Business Entities.” ASU 2021-09 requires that when the rate implicit in the lease is readily determinable, the lessee must use the implicit rate in calculating its lease liability. However, when the implicit rate is not easily known, the lessee can use the risk-free rate3 by class of underlying assets, rather than on an entity-wide basis, to use a risk-free rate as the discount rate when measuring and classifying leases.

SUGGESTED ACCOUNTING APPROACH

Following is a case study in which we will walk through the accounting transactions for an operating lease because this is the most common type of lease for non-profits.

Assume the following facts:

• Nonprofit Lessee A negotiates a 3-year building lease on January 1, Year 1.

• The estimated economic life of the building is 40 years.

• The cost of the lease payments is $50,000 per year during the lease term payable at the beginning of each year.

• Nonprofit A incurs initial direct costs of $15,000.

• Nonprofit A’s implicit rate in the lease is not known. However, it determines that its incremental borrowing rate for a similar term is 5.5 percent at the lease commencement date.

Note: All amounts are rounded to the nearest dollar.

Following ASU 2016-02 and ASU 2021-09—Leases (Topic 842), the nonprofit lessee should:

a) Recognize an ROU asset and a lease liability measured at the present value of the lease payments in the Statement of Financial Position.

b) Recognize a single lease cost and amortize that cost on a straight-line basis over the lease term.

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3 The risk-free risk is the rate the US Government pays for its debt instruments. FASB used the example of a US Treasury (Treasury) Rate as the risk-free rate. Treasury publishes its yield on a security “from its time to maturity based on the closing market bid prices on the most recently auctioned Treasury securities in the over-the-counter market.” Note that some entities cited the Treasury Bill (T-Bill) rates. However, T-Bills’ common maturity does not exceed a maximum of 52 weeks while most operating leases last longer than one year.

c) Report cash payments in the Statement of Cash Flows under the Operating Activities subsection. In addition, the lessee should include costs of the ROU asset that include:

a) The lease liability.

b) Lease payment made at or before the lease commencement date less any lease incentives received.

c) Initial direct lease costs.

Facts as presented in tabular format:

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4 See Microsoft Office Support for present value calculation formula.

5 Interest expense at year 1 is $0 as the lease payment is made at the beginning of the year.

The Lease Prepayment and reversal entries shown above should be repeated in years 2 and 3 when the payment is made at the beginning of the year. In addition, as the first lease payment is made in advance at the beginning of year 1, no interest expense is recognized.

The lessee will record the annual lease plus interest expenses of $55,000, which equals the lease payment of $50,000 plus the amortization of $5,000 direct costs each year.

The Right-of-Use Asset and Lease Liability accounts will amortize to zero, and the total lease payments and direct costs will total $165,000 at the end of the lease term.

It is important to note that in our example, the Right-of-Use Asset amount is greater than the Lease Liability present value amount because the ROU includes the initial direct costs of $15,000 that must be amortized on a straight-line basis over the lease term. In addition, the lease interest should be amortized in accordance with the present value amounts computed at lease commencement. See ASU-20-55-29 for the analysis of the annual lease expense.

CONCLUSION

FASB’s ASU 2021-09—Leases (Topic 842) aims to increase transparency on a nonprofit lessee’s balance sheet. To achieve proper accounting for all lease-related transactions, an entity should first establish a process to account for all leases, including contracts that include lease components. The term of each lease must be individually assessed, and its impact calculated and recorded. Accounting policies should be established to ensure proper controls are implemented. Many software programs are available to help with the calculation of multiple and complex lease components. Most importantly, communication with all relevant stakeholders throughout the entire process—from lease initiation to reporting—should take place in a timely fashion.

A nonprofit entity can make a sizable commitment via leasing. Education/training for those in the organization who are unfamiliar with FASB’s ASU lease reporting requirements should be provided. Key controls should be established with stakeholders’ buy-in and monitored continuously to ensure management’s assertions as to leases’ existence, completeness, valuation, and presentation are supported.