Concrete Office Review Document

ASU 2016-02 (Topic 842) changes the way your charter school accounts for leases and presents them on your financial statements. Make sure you’re ready to comply.

Regulations

Charter Schools Must Prepare for the New Lease Accounting Standard

  • Marlen Gomez
  • 3/21/2018

Charter schools with public debt (such as municipal bonds) will have to implement FASB’s new lease accounting standard (ASU 2016-02, Topic 842) in fiscal year 2019-2020. All others must comply in fiscal year 2021. There are many things your school needs to do to prepare, including educating your board members and other financial statement users on the changes and how they will affect your financial statements.

Chief among these new requirements are the recognition of operating lease assets and liabilities on the lessee’s statement of financial position, and the disclosure of key information about leasing arrangements. These could have a significant financial impact on your charter school’s balance sheet.

First preparation steps for complying with the new lease standard

Your charter school should first identify all your leases. This may mean you have to read through contracts to determine which of them contain leases. A lease is defined as a contract (or part of a contract) that, in exchange for consideration, conveys the right to control the use of identified property, plant, or equipment for a period of time.

Once you’ve identified all your school’s leases, you will need to have all the terms, conditions, facts, and circumstances relevant to each lease documented. This includes but is not limited to commencement dates, terms, end dates (including all options to extend if the lessee is reasonably certain to exercise the options), lease payment amounts, and any purchase options.

The next step is to classify the lease as a finance or operating lease. The lease is a finance lease if it meets any of the following criteria:

  • The lease transfers ownership of the leased asset to the lessee on or before the end of the lease term.
  • The lease gives the lessee an option to purchase the asset, and the lessee is reasonably certain to exercise that option.
  • The lease term represents the major part of the remaining economic life of the leased asset. (However, if the leased asset is at or near the end of its economic life as of the beginning of the lease, this criterion is not applicable.)
  • 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 leased asset.
  • The leased asset is so specialized for a particular purpose that it is not expected to have an alternative use to the lessor when the lease is over.

If none of the criteria above is met, the lease should be classified as an operating lease.

Calculating the right-of-use asset and lease liability for the lessee

The lease liability is measured at the present value of the remaining lease payments, using a discount rate based on the rate implicit in the lease, if it can be determined. Otherwise, the lessee should use its incremental borrowing rate. However, nonprofit organizations can elect an accounting policy to use a risk-free discount rate.

The right-of-use asset is measured as the sum of:

  1. The lease liability as measured at the beginning of the lease,
  2. Lease payments made to the lessor on or before the commencement date (less any incentives received), and
  3. Any initial direct costs that the lessee incurred.

In some instances, the right-of-use asset and the lease liability may be the same amount.

For finance leases, as the lessee, you should generally recognize amortization expense for the right-of-use asset, interest expense related to the lease liability, and any variable lease payments incurred in the period, which were not included in the lease liability. Generally, amortization should be calculated on a straight-line basis over the shorter of the end of the useful life of the right-of-use asset or the end of the lease term. As the interest is recognized, the lease liability increases, and as lease payments are made, the lease liability decreases.

For operating leases, you should generally recognize a single lease cost representing the straight-line allocation of the remaining cost of the lease over the remaining lease term and variable lease payments incurred in the period that were not included in the lease liability.

Sample calculations

Let’s say your charter school must determine how to account for a lease that commences today and has a 20-year term with annual lease payments of $150,000, paid monthly.

We will assume there is no ownership transfer or option to purchase the asset, and the asset is not so specialized for a particular purpose that there would not be an alternative use. We just need to figure out if the present value of the total lease payments equals or exceeds the fair value of the asset, or if the lease term is a major part of the economic life of the asset.

To calculate the present value of the total lease payments, we will apply the incremental borrowing rate (estimated at 4 percent) because the rate implicit on the lease is not readily available. So the present value is calculated at $2.06 million Compared to a fair value of $5 million, this represents 41 percent of the fair value. Because this is below 90 percent, the test is not met.

To check the economic useful life, we noted that the estimated useful life of the asset is 30 years, and the lease term is 20 years, which is 67 percent of the total estimated life of the asset. Because this is below 75 percent, this test is not met and, by default, the lease is considered an operating lease.

The right-of-use asset and liability are calculated as follows:

Required information
T-bill rate 2 percent
Monthly payment $12,500
Number of payments 240 (12 monthly payments for 20 years)
Lease liability
$2,475,043.64 (present value calculation)

Assuming there were no payments made to the lessor on or before the commencement date, no incentives were provided, and there were no initial direct costs, the right-of-use asset will be the same as the lease liability calculated above. And the journal entries needed for this operating lease are as follows:

Initial recording
DR: right-of-use asset $2,475,043.64
CR: lease liability $2,475,043.64
Monthly
DR: lease expense $12,500
CR: cash/AP $12,500
Monthly
DR: lease liability $10,312.68
CR: right-of-use asset $10,312.68

If, for the example above, the present value of the leased asset equaled or exceeded 90 percent of the fair value of the asset, then the lease would have been determined to be a finance lease. Example journal entries to record this lease are as follows:

Initial recording
DR: right-of-use asset $2,475,043.64
CR: lease liability $2,475,043.64
Monthly
DR: amortization of right-of-use asset $10,312.68
CR: right-of-use asset $$10,312.68
Monthly
DR: lease liability $12,500
CR: cash $12,500
Monthly
DR: interest expense* $4,125.07
CR: lease liability $4,125.07

* Interest expense is variable based on an amortization schedule

Other considerations

Although the new lease standard impacts all operating leases, keep in mind the financial impact this could have on your balance sheet. Once you have calculated the right-of-use asset and liability, you should consult with your auditor to determine if it will materially impact your financial statements.

If your charter school has to meet covenants, make sure you are still complying with your covenants. If not, talk to your lender about the potential issue before implementation.

How we can help

CLA charter schools professionals know how broadly FASB’s new standards can affect your organization and impose administrative burdens. We can guide your people through the implementation process, train your staff and board members, and help you fully prepare to comply with the new lease accounting rules.