This column continues to address the important topics that our firm covered in a series of client education events for tax-exempt organizations across New York state. On a personal note, after 43 years in public accounting, I continue to believe that the accounting rule-makers issue new requirements and pronouncements in some cases with the objective of improving job security for auditors and CPAs.
Our profession now has more than 1,000 pages of standards on how an audit should be conducted. For those of you who think that an audit is just an audit and that one auditor is the same as the next, I can assure you that nothing could be further from the truth. In addition to a plethora of auditing standards, we also have more than 5,000 pages of accounting and financial reporting rules that make up what is commonly referred to as Generally Accepted Accounting Principles (or GAAP).
GAAP is the baseline and technical requirements for almost all audited financial statements. It is particularly interesting to note that the first topic discussed below, “Accounting for Leases,” required more than 600 pages of narrative to describe what will be a massive change in accounting for almost all lease obligations exceeding a one-year term. So, between generally accepted auditing standards and GAAP, I am sure that my chosen profession will continue to have job security long after I find myself six feet underground.
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The best news regarding the lease-accounting standard is that its requirements do not have to be adopted until calendar-year 2019 or calendar-year 2020, depending on whether you are deemed to be a “public business entity.” Most, but not all, tax-exempt organizations will need to adopt this accounting standard for 2020 unless the organization is obliged to satisfy certain public-debt obligations. You may say, “Why do I need to be concerned about this if it doesn’t apply until 2020?” The short answer is that in addition to the massive change comment referred to above, virtually every nonprofit organization with substantial numbers of leases will need to amend and re-negotiate its bank-debt agreements that contain any loan covenant provisions.
The most significant change in financial reporting will be that the present value of all lease obligations, both capital and operating leases, will be recorded as an asset and liability on the face of the organization’s balance sheet. Why, you might ask, is that significant?
For the past 40 years, accounting rules have distinguished and segregated all lease obligations in two types. Capital leases have been recorded on the balance sheet on the theory that the organization was effectively purchasing or would own the asset at the end of the lease term. Operating leases, however, in which there is usually no intent to own the building or equipment being leased, have always been reported as a footnote commitment or obligation. Every organization with operating leases would have disclosed a lease-commitment footnote that would summarize the remaining rental-payment obligations in the aggregate for all operating leases entered into by the organization.
Now, in what I consider to be the questionable wisdom of accounting rule-makers, they have decided that all leases, including operating leases, should be reflected on the organization’s balance sheet as a long-term asset and corresponding liability. The amount of the liability to be recorded is calculated at the present value of the remaining lease commitments. As a result, organizations that have utilized operating leases as a financing strategy will now be adding potentially significant amounts to both their asset values and related liabilities, even though the organizations may never have any intention of purchasing, acquiring, or taking title to the leased asset.
I know that this is confusing, so let me use an example to illustrate, in an admittedly extreme manner, the potential bombshell that can result. For assumption purposes, a nonprofit organization has total lease obligations that were formerly classified as operating leases of $5 million. The present value of the future lease commitments, calculated using a current discount rate, for identifying the financing interest component is $4 million. In addition, at the date of adoption of the new lease-accounting standard, the organization has total liabilities of $4 million, with a total net asset / fund balance amount of $2 million.
In the example above, the liabilities of the organization are twice the amount previously reported, and the debt-to-net-asset ratio is also doubled to 4 to 1 — from 2 to 1. Those of you who understand the concept of “leverage” will also know that the entire leverage amount or ratio can be viewed as a limitation on the organization’s debt-financing capacity and possibly create cash-flow and debt-repayment concerns.
The definition of a lease has also been clarified in the new standard: “A lease is a contract, or part of a contract, that conveys the right to control the use of identified property, plant or equipment (an identified asset) for a period of time in exchange for consideration.”
The definition and the new accounting rules will require asset and liability recognition on the face of the organization’s balance sheet. Leases will still be categorized as either financing (purchase or acquisition) or operating. Again, the massive change is the potentially significant increase in the amount of liabilities reflected on the organization’s audited balance sheet.
As is my normal practice, I offer the following recommendations for purposes of adequately preparing your board and your banker and, in some cases, your government-funding sources for this massive change. Ask yourself these questions:
1. Does your organization have a high volume of lease transactions?
2. Does your nonprofit have complex lease agreements?
3. Is your lease origination / authorization process decentralized?
4. What technology application and/or reporting system do you use or have available to monitor and track leasing activity?
5. Are you certain that all your current lease arrangements are properly recorded and disclosed in your financial statements?
6. Have you had a discussion with your bank’s or banks’ lending officers about the effect of this pronouncement on loan covenants and financial-ratio requirements?
7. Have you confirmed with your banker whether the new accounting pronouncement will require an amendment or renegotiation of your current debt agreements?
8. Have you properly addressed the impact of the revised lease accounting on all other external users of your financial statements, particularly government funders, vendors, and grant-making sources?
9. Have you identified and are you maintaining all the necessary documentation in a centralized database so that all necessary disclosures can be easily identified for purposes of preparing and issuing audited financial statements?
10. Last, but certainly not least, there may be some cost advantages in negotiating the leases that you will enter into between now and the effective date. This rationale is based on the fact that the accounting rules for lessors will not be changing, and, as a result, there may be a distinct advantage to the lessor in structuring the lease terms and conditions.
And, by the way, after 43 years in public accounting, I am going to continue working until I no longer have job security.
Gerald J. Archibald, CPA, is a partner in charge of the management advisory services at The Bonadio Group. Contact him at (585) 381-1000, or email: garchibald@bonadio.com