The accounting rule makers (that would be the FASB) have proposed massive changes to lease accounting. Essentially, all leases with a term over 12 months will be recorded as an asset with an offsetting liability for the lease payments.
A very rough analogy is that all leases in the future will be treated in somewhat the same way as a capital lease is handled today. Currently, there are very specific tests for determining whether to record an asset and liability. Meet one of the four very specific tests and the lease is capital. Miss all four of the tests? It’s an operating lease. A large portion of leases are currently treated as operating leases.
Biggest impact: For the audience in the nonprofit community that will be reading this blog, the biggest impact will be for office leases. You will have to record an asset and long-term liability for the value of your office lease. That will affect all NPOs that do not own their building. The second biggest impact is those equipment leases for things like vehicles, copiers, and postage meters. I think that essentially all NPOs will have to go through the lease calculations to book an asset and liability for their leases.
Why the change? The first sentence of the exposure draft shows the FASB’s thought process. It reads “leasing is an important source of finance.” So if leasing is a major financing source for organizations, don’t you suppose that FASB would conclude that all of that financing should be shown as a liability on the financial statements? From a different perspective, the FASB thinks that if you have the right to use an office or piece of equipment, then you have an asset that should appear on the financial statements. Likewise, if you have a fixed stream of payments you expect to make, then there is a liability that should be recorded. Their thought process is that if you just signed a 5-year lease on office space, you have acquired an asset that should be recorded and incurred a 5-year obligation that should be booked as a payable.
How is the lease calculated? The amount to be recorded as an asset will be called the ‘right-to-use asset’. The asset and related liability will be calculated at the discounted present value of the payments over the term.
Term used for calculating right-to-use asset: If there are several renewal terms or other complications on how long the asset will be leased, an organization will have to assign probabilities to the length of each option. The longest term that has more than a 50% likelihood of being the actual term will be what is used for the calculation.
Interest rate: Organizations will use their incremental borrowing rate to calculate the present value.
Payment amount for calculation: If there are built-in increases that will vary based on future events, such as linking payment increases to CPI, then organizations will have to make an estimate of the likely increases in the future and use those payments for the calculation.
Overall, the accounting for leases will be much more complex.
This is a summary explanation of the proposed changes. As already mentioned, a more detailed discussion is found here.