Lease Standard Education Series for Nonprofits – Lease Identification and Lease Term
Lease Identification
Identifying leases is step one in the lease journey. ASC 842 defines a lease as a contract, or part of a contract that conveys the right to control the use of property, plant, or equipment. Here are places you can start to look to help make sure you have a complete inventory of all your leases.
Financial Statements
Look at your financial statements to find information on existing leases. The footnotes should disclose material operating and capital leases. Once you identify your leases, find the written agreements so you gather all your information in one place.
Service Contracts
Read your service contracts. These may include the use of an asset as part of the service. One of the principals at CLA likes to say, “Think about coffee. If you have a service to provide coffee to your place of business, the coffee machine is a part of the service contract. That could be a lease!”
Accounts Payable and General Ledger
Review the accounts payable and general ledger expense activity for payments that repeat monthly or quarterly to a vendor. These may require further analysis to determine if an embedded lease exists.
Lease Term
Another important initial step is to determine the term of your leases. You should evaluate the lease term at the commencement of the lease to warrant proper accounting. You start with the lease term stated in the contract and then consider other factors like:
- Renewal clauses – These clauses can extend the lease term.
- Termination or cancelation clauses – These clauses can shorten the lease term.
Some questions to ask when dealing with these clauses:
- Is there a history of renewals or cancellations? Are there economic incentives to renew or cancel?
- What is the your expectation going forward regarding renewal or cancellation?
- Does this renewal option or termination clause meet the threshold “reasonably certain of exercise”. (Reasonably certain of exercise means, unless something unexpected happens, the renewal or termination clause is to be exercised.)
Other issues to consider include month-to-month leases, unwritten leases, and leasehold improvements.
Month-to-month leases, with no formal renewal options, report payments for rent and leasehold improvements as expenses as incurred. Formal renewal options can be subject to judgment especially when considering related-party leases. There are those who feel that a month-to-month lease automatically renews every month, which could indicate that the lease term is longer. This fact pattern, when considered with the history of renewal may indicate a longer lease term. You may conclude that based on the history of renewal and intentions of related parties, the lease may be a finance lease. Professional judgment is necessary for these types of situations.
When a lease does not have a written agreement, it is difficult to determine legal enforceability. You should consider drafting a formal written agreement to support the substance of the transaction.
Leasehold improvements are amortized over the shorter of the lease term or the useful life of the asset. In many cases, related-party businesses would amortize the leasehold improvements over a period greater than the lease term concluding the economic substance supported renewal of the lease because it is in the control of the common owner which was reasonably assured. Under ASC 842, this changes, as the lease is reported based on the legal enforceability of the lease term and the leasehold improvements are amortized over the shorter of the lease term or useful life of the asset. This could result in amortizing leasehold improvements over a shorter period for some entities or having to write off leasehold improvements in the year of adoption.
There is much to consider when implementing ASC 842, so take time to consider the details in your contracts.
How CLA Can Help?
The new lease standard is here. Be proactive to understand its impact on your nonprofit. CLA has the lease resources to help assess its impacts beyond general accounting and financial reporting, and walk you through readiness assessment, software selection and analysis, and implementation.
A turnkey lease accounting option can include:
- Assistance to identify and analyze leases that are subject to the standard
- Delivery of leased asset schedules, journal entries, and comprehensive footnote disclosures
- Updated and revised information at future interim or annual periods based on your needs
Lease Education Series
Stay tuned! In our next post we are taking a dive deeper into this new standard, looking at policy elections and practical expedients.
In case you missed or would like to recall upon any prior content, below is a running list of the educational series:
This content was created by CLA’s Ann-Marie WalshLaRocca, Nonprofit Director.
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