After many years (and also many delays), the implementation date for FASB ASU 2016-02, ASC 842, Leases, is upon us, specifically, for private companies and fiscal years beginning after December 15, 2021. While the new lease standard won’t impact many institutions’ 2021 financial statements, the implementation date is quickly approaching, and you can expect a sizeable impact to both financial statements and the composite score next year.
The impact of the new lease standard on educational institutions
The new lease standard requires institutions to record a right-of-use asset and a lease liability for most operating leases under the old standard. While the right-of-use asset will be subtracted from an institution’s equity, the lease liability will be added back to arrive at the adjusted equity used in the primary reserve factor. The amounts of the right-of-use assets and lease liabilities won’t offset one another exactly, but the expectation is that the overall offset will lead to a negligible change in the primary reserve factor from the old lease accounting to the new.
However, the same cannot be said for the equity reserve factor. The right-of-use asset will increase an institution’s total assets, which will negatively affect the equity reserve factor within the composite score calculation, as this factor is based on the ratio of modified equity over total assets. There will be significant detrimental impacts to this portion of an institution’s composite score based on the new standard.
The Department of Education’s Proposed Solutions
Given the impact of the new standard on the composite score, the Department of Education considered various transitionary steps to minimize the immediacy of the negative ramifications for financial responsibility. The Department ultimately settled on a compromise by applying the new FASB standard to all leases an institution entered into on or after December 15, 2018 (post-implementation leases). While all leases an institution entered into prior to December 15, 2018 would be treated prior to the new FASB requirements.
The Department did this to treat all institutions (publicly traded and private) fairly. The Department also clarified that any options exercised after December 15, 2018 for pre-implementation leases would be accounted for as post-implementation leases in the composite score. Unfortunately, given the circumstances of the past year and a half, many institutions might have lost the grandfathered, pre-implementation status due to any modifications made to their pre-existing leases in light of the pandemic. Whether they were planning on it or not, many institutions will have their composites scores impacted by the new lease standard starting as early as 2022.
What to Consider
Two key areas to focus on the new standard include leases between related parties and short-term leases.
A short-term lease is defined as a lease that has a term of less than 12 months and does not include an option to purchase the underlying asset that the lessee is reasonably certain to exercise. Accounting for short-term leases can avoid the recognition requirements of the new standard and instead follow the old methodology of expensing the payments evenly over the lease term. Keep in mind that while long-term facility leases will have the biggest impact to changes in the balance sheet and the composite score, an institution might also have many equipment leases that would have been recognized as operating leases under the old leases and now may not qualify as short-term leases. These leases would require an organization to implement the changes under the new accounting treatment. The volatility of a facility lease under 12 months might not be practical nor possible for many institutions. Going forward in future lease negotiations, the shorter duration of the lease term will generally lead to a smaller right-of-use asset and less of an impact to the composite score.
As discussed in a recent article specifically about related party leases found here, there are no exceptions for related party leases under the new standard. This is all the more reason to document the lease arrangement in a formalized lease detailing the legally enforceable terms, conditions and responsibilities of both parties involved. While there might be more flexibility in structuring a related party lease to lessen the impact on the institution’s financial responsibility ratios, remember that all related party activity must be disclosed in the institution’s annual financial audit.
At this point, another FASB delay on the new lease standard implementation for private companies is highly unlikely. Options are somewhat limited in planning for the 2022 financial impact of the new standard. Institutions need to take a proactive approach to analyzing their current portfolio of leases to understand the impact on the financial statements. Sikich provides a comprehensive handbook addressing the accounting treatment of the new standard which can be accessed here. Sikich also offers a proprietary, Excel-based ASC 842 compliance solution, Lessee Ledger, to prepare lease calculations, amortization schedules, monthly journal entries and quantitative financial statement note disclosure summaries.
The implementation of the new lease standard and the updates to the composite score calculation will most likely have a direct and material impact on your institution. Make sure your institution is aware of the implications and talk through your specific situation with a Title IV audit expert.