Accounting for Leases – Including a Proposed New Accounting Standard

By Dick Larkin, CPA

 - As of early 2011, Accounting for Leases is the subject of FASB Statement No. 13 and its numerous amendments (codified in topic 840 of the FASB Accounting Standards Codification).

Its requirements are not discussed in detail in this article as they are in no way peculiar to nonprofit organizations, and are discussed elsewhere.
Briefly, leases are currently classified as either “operating” leases or “capital” leases; the criteria for classification being, in essence, whether or not the lease amounts in substance to a purchase of the asset by the lessee. There are four specific criteria used in making this distinction. Leases meeting one or more of the criteria are capital leases; all others are operating leases.

Operating leases are not reported on the lessee’s balance sheet (statement of financial position); rather, each year’s rent is reported as an expense of that year, and the future obligation to make rental payments is disclosed in a footnote.

Capital leases are reported essentially as purchases by the lessee (similar, but reverse, criteria apply to the financial statements of lessors); the asset is capitalized on the lessee’s balance sheet, with a corresponding liability for the future lease payments. The asset is amortized over the lease term, and the liability is reduced by the periodic rental payments.

FASB (jointly with the International Accounting Standards Board) is currently working on a project to revise this standard, and had earlier decided that after some future date – probably within a couple of years, all leases would be accounted for in essentially the way capital leases are now. For operating leases, this change will normally have little effect on an organization’s income statement, since what is now reported as rent expense will henceforth be reported as amortization expense of a similar amount. The principal effect will be to gross up the balance sheet for the asset and liability described above, with little or no effect on net assets. An Exposure Draft (ED) to this effect was issued in 2010.

In many cases, this gross up will not matter to financial statement users; however, organizations should consider whether the increase in liabilities will negatively affect compliance with covenants contained in any debt and grant agreements to which the organization is subject. For example, if there is a covenant requiring the maintenance of no more than a certain maximum ratio of debt to equity (net assets), the debt amount will be higher, while the equity amount will probably not change, possibly causing the organization to be in violation of the covenant.

For example, suppose that under the current accounting rules, an organization’s balance sheet reports assets of $1 million, liabilities of $600,000, and net assets of $400,000. Its debt-to-net assets ratio is 1.5 to 1. Further suppose it is subject to a covenant requiring this ratio to be no greater than 1.8 to 1. Further suppose again it has leases now classified as operating leases, which, when their future obligations are calculated under FASB’s proposed new rules, will add another $200,000 of liabilities. Total liabilities will now be $800,000 (total assets will now be $1.2 million, so net assets will remain at $400,000) and the ratio will be 2.0 to 1 – in violation of the covenant.

Consequences of this violation might – depending on the terms of the debt or grant agreement – include:

• acceleration of the debt repayment schedule, including possibly making the entire amount immediately due
• inability to refinance or roll over the debt, or cancellation of a line of credit
• increase in the interest rate on the debt
• increased reporting requirements
• a requirement to post additional collateral
• cancellation of future grant payments on current grants
• inability to obtain future grants from that funder

Organizations should identify any such covenants to which they are subject, determine whether they are likely to find themselves in violation after the revised accounting standard takes effect, and, if so, discuss the matter with the other party to the covenant (lender or funder) to try to have the covenant modified.

Update on Types of Leases

At a joint meeting in February 2011, the FASB and IASB Boards (the Boards) tentatively concluded that there are two different types of leases, rather than a single type. The change in direction results from outreach activities and comment letter responses to the original proposal. Some Board members described the first type (the “finance” lease) as a contract in which the lessee essentially purchases the underlying asset by obtaining substantially all of its risks and rewards through the lease. The second type of contract (the “other-than-finance” lease) is intended to create more financial flexibility, to mitigate the risk of ownership (for example, technological obsolescence), and/or to outsource the maintenance of an asset.

The current working definitions for each type of lease are:

Finance lease – The profit or loss of a finance lease has a pattern consistent with the 2010 ED, including interest expense/income using the effective interest method, as well as the lessee’s amortization of its right-of-use asset. This profit or loss pattern reflects leases that contain a significant financing element where the right to use the underlying asset is conveyed on an installment basis.

Other-than-finance lease – A lease transaction in which the financing element is not considered significant. The profit or loss pattern of an other-than-finance lease is characterized by straight-line recognition.

The Boards plan to develop a principle and related indicators to distinguish the two types of leases.

In a finance lease, a lessee would record a right-of-use asset and corresponding liability. The liability would be amortized using the effective interest method, like a mortgage, and the right to use asset would be amortized, similar to depreciating a fixed asset. This treatment is the same as what the Boards originally proposed in the original ED.

In addition, since the Boards have tentatively agreed that the second type of lease contract does not contain a significant financing component, they intend to deliberate alternative attribution and presentation models for the income statement. In other words, the Boards will consider whether “rent expense” should be presented in the income statement, as opposed to the amortization and interest expense which would be presented under a finance lease. The Boards will also further evaluate whether a straight-line pattern of recognition—as tentatively indicated in the working definition—would be more appropriate than the accelerated pattern that results from applying the effective interest method to the lease payment liability.

In short, the Boards believe financial statement users will benefit from different income statement models to differentiate in-substance purchases from other leases. Finance leases will signal that the lessee has purchased substantially all of the risks and rewards of a leased asset by reflecting interest expense for the significant financing component. Conversely, other-than-finance leases will indicate when a lessee hasn’t substantively purchased the asset. But in all cases, a lessee will portray its rights and obligations under the lease by reporting a right-of-use asset and a lease payment liability on its balance sheet.

Shortly after the meeting, there were conflicting reports as to whether both types of leases would be recorded on the balance sheet, or whether only finance leases would create recognized assets and liabilities. We have now confirmed that the Boards continue to believe all leases should be recorded “on balance sheet,” consistent with the ED.