By Lee Klumpp, CPA, CGMA
In 2016, the Financial Accounting Standards Board (FASB) updated its lease accounting rules (ASC 842) and closed a diversity in practice in the previous standard. The major change is that organizations must now include lease assets and liabilities on their balance sheets. The upshot is that despite a recently granted extension that applies to private companies and nonprofits, the task of becoming compliant is urgent and challenging. Impacted nonprofits don’t have a moment to spare.
Under the previous standards, operating leases were off-balance sheet. That essentially allowed companies to omit certain lease assets and liabilities from their balance sheets, potentially skewing their debt-to-equity ratio. In 2016, the International Accounting Standards Board estimated that public companies using either the International Financial Reporting Standards or accounting principles generally accepted in the United States of America (U.S. GAAP) had around $3.3 trillion of lease commitments, 85% of which were not recorded on their balance sheets. This, of course, makes it difficult for shareholders (stakeholders), investors and lenders to get a true sense of an organization’s financial health. Under the previous ASC 840 standard, operating leases were only required to be disclosed in the footnotes of the financial statements. Under ASC 842, the only leases that may be omitted from financial statements are short-term leases with an original term of fewer than 12 months. ASC 842 increases transparency and comparability among organizations that enter into lease agreements and provides a clearer picture of an organization’s liabilities related to leasing obligations. ASC 842 also includes extensive disclosures intended to enable users of financial statements to understand the amount, timing and judgment related to an entity’s accounting for leases and the related cash flows as well as disclosure of both qualitative and quantitative information about leases.
But what it also does is implement a one-size-fits-all accounting standard that significantly increases the reporting burden on smaller, nonpublic companies, including nonprofits. Implementation will involve significant challenges and require major investments in time, money and other resources. Fortunately at its Oct. 16, 2019 meeting, FASB affirmed its decisions on two proposed Accounting Standards Updates (ASUs) – one of which extended the implementation deadline for the new standards on leases that were not yet effective for private companies and nonprofits to the first fiscal year after Dec. 15, 2020, instead of Dec. 15, 2019, as originally mandated.
Subsequently, in June 2020 the FASB decided to provide near-term relief for the adoption of the leasing standards based on feedback from stakeholders regarding challenges with the adoption as a result of the current business and capital disruptions caused by the coronavirus (COVID-19) pandemic. As a result, the FASB issued ASU 2020-05 which provides an additional one-year deferral of the effective date of the leasing standards. As a result, the leasing standards will now be effective for private companies and private nonprofits for fiscal years beginning after Dec. 15, 2021. Public nonprofits who had not issued their statements as of June 3, 2020, can also opt to defer adoption until fiscal years beginning after Dec. 15, 2019. This is an elective deferral so entities can still choose early adoption if they wish.
This is good news for nonprofits, which now have extra time to implement these changes. However, it should also serve as a wake-up call, as many organizations weren’t even aware of the change and the need to become compliant. Even within this updated timeline, ensuring compliance will be a significant effort.
Nonprofits face multiple significant implementation challenges such as:
- The number of business arrangements that were previously not identified as leases may now be identified as meeting the definition of a lease or embedded lease
- Existing systems and processes may need to be modified or enhanced in order to provide information necessary to address the new reporting and disclosure requirements
- Multiple departments across the organization will be affected by this standard, including information technology (IT), tax, legal, treasury, and financial planning and analysis, among others
- Ongoing efforts to remain compliant might be more significant than the initial implementation effort
It’s clear that complying with ASC 842 is a time-consuming process. Organizations should develop an implementation timeline keeping several factors top of mind, including existing lease commitments, data governance maturity and cross-function coordination needs.
To get started, organizations should first learn one of the key lessons from public companies that have already gone through this process: The standard requires the collection of significant data from every lease and business arrangement that could contain an embedded lease that exists on, or will exist after, the effective date. Analyzing leases and business arrangements to identify and extract those details for inclusion in the organization’s financial reports requires substantial time and resources. It is crucial to identify the full population of leases upon adoption of ASC 842.
Nonprofits should also consider adopting the following best practices:
Solicit the involvement of the entire organization: Although the implementation of ASC 842 is primarily the responsibility of the organization’s accounting department, successful implementation requires support from across the entity, especially when an organization has a large real estate portfolio or embedded leases. This may mean seeking assistance from IT, legal or procurement departments. Soliciting executive sponsorship to champion implementation will also help to streamline the process.
Use technology to your advantage: Under the stress of deadlines, the compilation of lease terms and data can be daunting, especially within larger nonprofits where leases may exist across departments – and possibly internationally if the organization has international operations. For organizations that have developed a robust data governance program or specific procedures to collect and manage enterprise data, implementation should be considerably easier. However, for the many organizations that have yet to build out these structures, there are off-the-shelf and purpose-built technology solutions that can help standardize and aggregate the information.
Keep an open line of communication: Organizations that maintain a large physical footprint are impacted the most. They should factor in extra time for both implementation and keeping stakeholders informed. Unexpected roadblocks, such as a delay in receiving necessary data from external sources, should also be accounted for in the timeline. Benchmarking the organization’s progress on implementation against its timeline throughout the process is paramount in keeping on task and meeting goals.
The bottom line is that even with the extension, it will take a concerted effort to become compliant in time. Nonprofits need to start the implementation process now.
Adapted from article in the Nonprofit Standard blog.