Accounting for Leases – Major changes proposed

Washington Monument September 2011, Andrew Young, Manager, Renner and Company, CPA, P.C.
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A new accounting standard involving lease agreements proposed by the Financial Accounting Standards Board (FASB) will affect the financial statements and budgeted projections of all non-profit entities possibly as early as next year.  FASB’s recently issued Proposed Accounting Standards Update – Leases (Topic 840) outlines changes to its current accounting standards for lease agreements by eliminating the “operating lease” as defined under current accounting standards.  An entity’s recorded “operating” leases will now be considered “capital leases” as defined by current accounting standards under the outlined change, including operating lease agreements already in effect and rentals of office space.  As a result, non-profit entities will need to be aware of how these outlined changes affect their balance sheet and budget projections, especially during the first few years of implementation upon FASB’s anticipated ratification of the proposal.

Office Lease Would Create Asset

The first significant change a non-profit entity will need to evaluate is the recording of additional assets and liabilities and the elimination of deferred rent liability on the entity’s balance sheet.  All “operating lease” agreements will be capitalized and recorded in the same manner as a “capital lease” as defined by current standards.  For example, assume that an entity has a five year “operating” copier lease with payments being made on a monthly basis.  Also, assume a 10 year “operating” lease for office space rental with monthly payments increasing by 3% each year.  Current accounting standards state that no asset or liability would be recorded on the balance sheet for either of the leases.  A deferred rent liability would be recorded to represent the yearly increasing payments related to the office space lease. 

Proposed standards however indicate that each lease would be capitalized as an asset (valued at cost) and depreciated over its economic useful life.  Also, the entity would need to record a liability for the leases (also valued at cost) and, as an additional measure, factor in an interest rate for the lease’s monthly payments to reflect costs of usage for the newly capitalized property.  Monthly payments would be split between principal, the amount reducing the liability, and interest, the amount expensed, not reducing the liability.  This newly recorded liability would then also eliminate the concept of deferred rent; no corresponding liability for deferred rent would need to be recorded on the balance sheet.    Users of the non-profit entity’s balance sheet would then need to factor in these additional assets and liabilities and its corresponding equity in evaluating the entity’s financial position.

Interest and Depreciation Will Increase

Another significant change the non-profit entity will need to evaluate is the additional interest and depreciation factors on an entity’s projected budget and cost management strategies.  Assuming the same examples as the prior paragraph, the proposed standards create additional right of usage costs in the form of interest that were not previously factored into a non-profit entity’s profit and loss statement under current accounting standards.  As part of good governance, additional interest costs would need to be factored into an entity’s projected budget and a strategy should be developed to compensate for these additional costs through revenue generation.  As interest costs are higher at the beginning of a lease term, an entity should be particularly cognizant of the short-term effects on projected net income.  Non-profit entities may lean towards an aggressive fundraising strategy to compensate for these additional interest costs.  A reduction in budgeted expenditures in other operating areas also provides another strategy to compensate for these additional interest costs.

Analyze Changes Now

While FASB’s recently issued Proposed Accounting Standards Update – Leases (Topic 840) is not expected to be implemented until next year, non-profit entities need to analyze the proposed changes today to determine their effect on their balance sheet and budgeted projection.   By factoring the additional recording of assets and liabilities on the balance sheet and additional interest costs required with the proposed standards, non-profit entities can be certain of compliance with these standards upon implementation.  Analyzing the proposed standards would also allow entities to determine the best strategy to offset these additional costs and plan for a solid financial future.

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