The new lease accounting standard, ASU 2016-02 (Topic 842), is set to take effect for not-for-profit organizations that have issued, or is a conduit bond obligor for, securities that are traded, listed, or quoted on an exchange or an over-the-counter market, with fiscal years beginning after Dec. 15, 2018 and for all other not-for-profits for fiscal years beginning after Dec. 15, 2019. Issued by the FASB in February 2016, the new standard significantly affects the way leases are recorded on the balance sheet. While there has been considerable emphasis placed on understanding what will change under this new standard, it is just as important to understand what will remain the same.
A client recently approached us and presented an interesting question. His not-for-profit organization utilizes office space that is contributed, or donated, to the organization on an annual basis. The organization pays no rent to the donor and there is no formal agreement in place governing the use of this space, meaning there is no defined period of use or set value of rent. Naturally, the client wanted to know how the new standard would affect the organization’s accounting.
Our client was surprised to learn that the new standard would have no impact on their accounting as this scenario was not within the standard’s scope.
The new ASU defines a lease as a contract, or part of a contract, that conveys the right to control the use of identified property and equipment for a period of time in exchange for consideration. The above scenario is for an unspecified amount of time without the exchange of cash or other consideration. As such, there is no contract formed and this standard is not applicable.
Under the scenario described above, the client would simply record contribution revenue in the period in which the contribution is received and rent expense in the period in which the facilities are used at fair value. There is no balance sheet impact. Assuming fair value of rent for the office space used is $50,000 per year, the client would record contribution revenue and rent expense for this amount on a periodic basis.
Modifying the facts above slightly, let’s assume the client enters an agreement with an unconditional promise from the donor to utilize the office space for three years. The client will continue to pay no rent or other consideration. As such, there is no exchange for consideration and the standard continues to be not applicable. However, the accounting for the transaction changes due to the multi-year agreement. The client would contribute revenue and the corresponding contribution receivable at the present value of the total known future donated rent’s fair value in the period contributed. The client would then recognize rent expense in the period of use and amortize the receivable over the specified three-year period.
In this new scenario, let’s assume the fair value of the rent will increase five percent each year, starting at $50,000 in year one and increasing to $52,500 in year two and $55,125 in year three for a total contribution of $157,625. The present value of the rent (assumed discount rate of five percent) totals $142,857. The payments would be amortized as follows:
In year one, the client will record a contribution receivable and contribution revenue in the amount of the present value of the future rent of $142,857. The client would then record rent expense and a reduction of the receivable in the amount of $50,000. They would also recognize the amortization of the time value discount of $7,143. Years two and three would be handled similarly, adjusting the amounts for the increase in the fair value of rent.
While the new standard doesn’t apply in the two scenarios noted above, there are situations in which a not-for-profit organization may receive contributed rent which would be affected by the new standard. One common case that would bring the new standard into scope is below-market rent.
For instance, modifying the facts of our preceding example, instead of the client receiving free rent, it instead pays $10,000 in rent each year, significantly below market rate. There is no transfer of ownership of the office at the end of the lease, nor is there an option to purchase the office at the lease’s conclusion, and no other criteria which would cause the lease to be considered a finance lease are present.
Per the details of our scenario above, an operating lease is present. A total of $30,000 consideration is given over three years, $10,000 in each year. The present value of the consideration (assumed discount rate of 5%) totals $27,232.
As shown above, the client would record a right of use asset and a lease liability on the balance sheet. In addition, the client would record the cash payment of the lease by reducing the lease liability and also amortize the right of use asset over the course of the lease.
The contributed portion of the rent (the excess of the fair market rent over the rent paid) is treated like the donated rent in the previous example, with contribution revenue and the corresponding contribution receivable recorded at the present value of the total known future donated rent in the period contributed. The client will then recognize rent expense in the period of use and will amortize the receivable over the term of the lease.
As noted above, this scenario was for an operating lease. If the lease is a financing lease, the amortization of the lease liability would be treated as interest expense. In addition, the amortization of the right of use asset would be treated as amortization expense on a straight line basis.
The new lease standard could significantly impact the balance sheets of not-for-profit organizations. However, the first step in approaching the new standard is to determine whether your organization is dealing with a lease at all. With the standard’s effective date looming, it is critical that not-for-profit organizations understand and evaluate how it will affect them and how to implement any changes that may be required.
As always, UHY is here to help! Please do not hesitate to contact us with any questions.
Wednesday, April 24, 2019 | 7:30 AM – 9:30 AM EDT | The Hartford Club