Lease Accounting Changes

Many nonprofit organizations lease space or office equipment for their operations.  During 2022 the accounting for these leases changed.  If your organization has leases and follows the accrual basis of accounting, your year-end audited financial statements will look a little different.

Depending on the agreement, a lease is either considered operating or capital.  Under an operating lease, the property is owned by the lessor and the lessee (nonprofit organization) is only using it.  The monthly rent payments are recorded as an expense.  Under a capital lease, the property is considered an asset of the lessee.  The value of the property is recorded as an asset on the books of the lessee (and depreciated), along with a liability for the total lease payments to be made.  The monthly payments include principal, which is applied against the liability, and interest which is expensed.

The new accounting standard (ASU 2016-02, Leases (Topic 842)) went into effect for years ended December 31, 2022, which changed the definition, classification, and disclosures for leases.  Instead of operating and capital leases, we now have operating and financing leases.  There are certain criteria which must be met to be considered a financing lease, which includes the transfer of ownership of the asset, an option to purchase the asset that will likely be exercised, among other requirements.  Leases that do not meet the definition of a financing lease are considered operating.

Under the new standard, both operating and financing leases result in the addition of an asset and liability to the statement of financial position.  A calculation is done to determine the total liability for the lease plus a discount rate. This value is recorded as an asset called “operating lease right-of-use asset” or “financing lease right-of-use asset.” A corresponding liability is also recorded called a “operating lease liability” or “financing lease liability.”  When monthly payments are made, an expense is recorded as well as an entry to reduce the asset and liability.

The requirement to include operating leases as an asset and liability may impact organizations with loans that have covenants that must be met.  Depending on the covenants, adding the additional liability may adversely affect the covenants.  If you haven’t already, make sure you reach out to your lender to understand how this change will impact your loan covenants.

Contributed by: Carrie Minnich, MAcct, CPA | Partner | DWD CPAs & Advisors