Lease Accounting Changes: How Your Higher Education Institution Can Prepare
FASB’s new standard on lease accounting, ASU 2016-02 (Topic 842), is the culmination of a project that had been in process for nearly 10 years. Though the long-awaited standard was released in February 2016, the recently issued guidance is what grabs our attention now: virtually all leases are to be recorded on your balance sheet, and there’s much more to the standard than just accounting for these transactions.
Your higher education institution should review your current business processes and devise a strategy for implementation of the new requirements before the effective dates.
- For institutions with public debt, the effective date is for fiscal years beginning after December 15, 2018.
- For all other entities, the update goes into effect for fiscal years beginning after December 15, 2020.
To help you prepare for what’s ahead, here’s a review of the most significant changes and what you can do to implement a compliant lease review and accounting process.
Leases sorted into “finance” or “operating” categories
The most significant change in the updated standard is the differentiation between two types of leases: finance and operating. This will impact how you present your college’s or university’s leases on your financial statements.
Leases that are longer than one year in duration will be capitalized and recorded on the statement of financial position as a right-of-use asset and corresponding lease liability. A related lease expense will be recognized in the statement of activities, but classification of the lease will be either operating or finance, depending upon the terms.
To be classified as a finance lease, it must meet one of the following criteria:
- The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
- The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.
- The lease term is for the major part of the remaining economic life of the underlying asset (unless the lease occurs near end of economic life).
- The present value of the sum of the lease payments and any residual value guaranteed by the lessee equals or exceeds substantially all of the fair value of the underlying asset.
If the lease does not meet any of the criteria detailed above, it will be considered an operating lease.
Regardless of the type of lease arrangement, the right-of-use asset and lease liability will initially be measured at the present value of the lease payments in the statement of financial position. Under finance leases, interest on the lease liability will be recognized separately from amortization of the right-to-use asset, whereas under operating leases the cost of the lease is allocated on a straight-line basis over the lease term.
Lease review and process changes
On the surface it may appear this only impacts the presentation of leases on your institution’s financial statements. However, you will need to analyze your institution’s lease transactions and assess the processes used to enter into lease arrangements. Throughout the organization, those involved in these transactions must be educated on the new requirements. It will be especially important to review debt agreements and covenants to ensure no violations result from these changes.
Four steps to help transition to the new guidance
There are four things your institution can do to prepare to implement the new rules.
- Build a team — As your institution begins the implementation process, it is important to build a team with members from various departments. Obviously, there should be representatives from finance, but you should also recruit members from other affected departments, including facilities, procurement, legal, and information technology. It is crucial for key employees in each of these groups to be educated on the new standard and what to look for when reviewing or entering into lease agreements.
- Get organized — Take an inventory of all lease arrangements held by your college or university. Make a list of each lease, including the start and end dates and significant terms. Also ensure your institution maintains an executed lease agreement on file to support the listing.
- Do the math — Estimate the potential impact that recording the lease asset and liability on the statement of financial position will have on key ratios, as well as items like debt covenants and your institution’s composite score. Start the conversation to restructure or revise covenants, as needed, to ensure continued compliance in future years.
- Devise a strategy — The implementation team should devise a timeline for adoption. Key considerations include whether to adopt early or wait until the effective date. Can your institution utilize existing software to track and account for leases, or should a new software be purchased? This entails a cost/benefit analysis unique to your institution, based on the number of leases and available resources on hand.
How we can help
CLA’s higher education industry professionals understand how these changes can significantly impact your institution on many levels, including the added administrative burden. We can guide you through the process and help develop an implementation plan for a smooth transition to the new lease accounting standard.