While Accounting Standards Codification (ASC) Topic 842 is applicable to all entities, the adoption of the new leasing standard by nonprofit organizations is bringing into focus some unique considerations that may impact the conclusion of whether a contract actually contains a lease.
What is a Lease?
To set the stage for some of the nonprofit-specific lease considerations to follow, it is important to understand the definition of a lease under Topic 842. A lease is defined as follows: “A contract is or contains a lease if the contract 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.”[1]
[1] See ASC 842-10-15-3.
Free or Reduced Rent
A nonprofit organization may be given space, equipment or other assets to use free of charge, or be charged below-market rates for these items. For these types of transactions, a nonprofit organization must consider whether to apply ASC Topic 842, Leases, ASC Topic 958-605, Not-for-Profit Entities Revenue Recognition – Contributions, or a combination of both standards. Let’s illustrate these concepts with some specific examples.
Example 1: Free Rent
Company A provides Nonprofit B with the right to use office space free of charge for five years. Company A retains legal title to the office building but allows Nonprofit B to use the space in furtherance of Nonprofit B’s mission. If Company A had rented the space to another entity, Company A would have charged $1,000 per month for the first year of the lease with a 3% annual escalation of rent for each additional year of the five-year term, which is considered to be the market value.
What’s the accounting for that?
On day one of the arrangement, Nonprofit B would record a contribution receivable, and related contribution revenue, for the full amount of rent payments over the five-year period ($63,710), discounted to present value using an appropriate discount rate.
The revenue is donor-restricted due to time and is released from donor restrictions as the contributed asset (the office space) is used each period. On a straight-line basis each reporting period, Nonprofit B reduces the contribution receivable balance and records rent expense representing its use of the office space.
What is the basis for the accounting?
The transaction in this example falls within the scope of contribution accounting under Topic 958-605 but not lease accounting under Topic 842, because Topic 842 requires an exchange of consideration.
In other words, because Nonprofit B does not pay Company A cash (or other assets) for the use of the office space, the transaction falls outside of Topic 842. If the contributed assets are being provided for a specific number of periods (in this example, the period is five years), the contribution revenue (and related receivable) should be recorded in the period received for the market value of the lease payments discounted to present value.[1]
If the arrangement in this example had not specified the period of use, Nonprofit B would have recorded contribution revenue and the related rent expense each reporting period based on the fair value of the space for that period.
[1] See ASC 958-605-25-2 and 958-605-55-24.
Example 2: Below-Market Rent
Company C provides Nonprofit D with the right to use office space for $250 per month for five years. Company C retains legal title to the office building, but allows Nonprofit D to use the space in furtherance of Nonprofit D’s mission. If Company C had rented the space to another entity instead, Company C would have charged $1,000 per month for the first year of the lease with a 3% annual escalation for each additional year of the five-year term, which is considered to be the market value. For purposes of this example, there is no variable lease cost, no non-lease components, no prepaid rent, no initial direct costs, and no lease incentives. We will assume a 3.5% risk-free rate for the calculation of the lease liability. We will also assume Nonprofit D will use 3.5% as the discount rate for the contribution.
What’s the accounting for that?
On the commencement date of the lease, Nonprofit D would record a lease liability equal to the present value of the lease payments totaling $13,550 (rounded) and a right-of-use asset in the same amount. For simplicity purposes, the present value calculations in this example are based on annual rather than monthly payment amounts. The contribution portion of this arrangement is calculated as the difference between the fair market value of rent ($63,710) and lease payments ($15,000) over the lease term totaling $48,710. Nonprofit D should record contribution revenue and a related contribution receivable[1] at present value of $43,870 on the commencement date of the lease.[2] Similar to the first example, the revenue is donor restricted due to time and would be released from donor restrictions as the contributed asset (the office space) is used each period. On a straight-line basis each reporting period, Nonprofit D reduces the contribution receivable balance and records rent expense representing its use of the office space. This example assumes a known fair market value for the rental payments. When such information is not known, organizations need to obtain such information directly from the lessor or find comparable market data for a similar asset with a similar rental term.
What is the basis for the accounting?
The transaction above falls within the scope of both Topic 842 and Topic 958-605. Because ASC 842 defines consideration as cash or other assets exchanged, as well as non-cash consideration (subject to certain exceptions), only the portion of the transaction requiring payment is considered to be a lease within the scope of Topic 842. The fair value of the lease minus the cash payments made represents the contribution revenue and related receivable.[3]
In both of the illustrative examples above, the contribution of free or reduced-rate office space represents a non-financial asset. Nonprofit organizations must consider the revised presentation and disclosure requirements for contributed non-financial assets as outlined in Accounting Standards Update 2020-07, Not-for-Profit Entities (Topic 958): Presentation and Disclosures by Not-for-Profit Entities for Contributed Nonfinancial Assets. This standard is effective for periods beginning after June 15, 2021.
Embedded leases
As nonprofit organizations review their activities and agreements to determine the universe of lease transactions, in both the year of adoption of Topic 842 and in subsequent periods, management should be aware that there may be leases “hiding” within service or other contracts. These types of contracts are referred to as contracts with embedded leases. The following chart provides some examples of service or other contracts where embedded leases may be present:
| Information Technology | Advertising | Inventory Management | Shipment of Goods or Materials | Food Service |
|---|---|---|---|---|
| May contain embedded assets like phones, computers, copies, servers, etc. | May contain embedded assets such as the use of a billboard. | Third parties may be engaged to assist a non-profit organization with inventory management. Use of warehouse space could be an embedded asset. | Use of a rail car or semi-truck. | Some organizations provide on-site cafeterias or vending machines. The use of the vending machines, freezers, refrigerators, soft-drink dispensers, etc. could represent an embedded lease. |
As part of internal policies and procedures related to accounting for leases, management should document, in the year of adoption and annually, how the universe of leases was determined, as well as how management considered the possible existence of embedded leases. While embedded leases may not be material to a nonprofit organization’s financial statements, an analysis to determine the relative value of such transactions should be performed nonetheless.
Use of the risk-free rate
As an accounting policy election, Topic 842 permits nonprofit organizations (specifically entities that are not public business entities) to use a risk-free discount rate for leases instead of an incremental borrowing rate, determined using a period comparable with that of the lease term.[4] The use of the risk-free rate may be a more expeditious approach for organizations that do not have a readily available incremental borrowing rate. As a reminder, Topic 842 defines the incremental borrowing rate as “the rate of interest that a lessee would have to pay to borrow on a collateralized basis over a similar term an amount equal to lease payments in a similar economic environment.” If an organization has a real estate lease with lease payments totaling $700,000 over the 10-year lease term, it would not be appropriate for the organization to use its $5 million, one-year, line-of-credit borrowing rate as the incremental borrowing rate because the term and amount of the borrowing is not similar. Organizations wishing to use an incremental borrowing rate that do not have such a rate readily available may need to use external parties such as banks or other lending institutions or valuation professionals to determine an appropriate collateralized rate for certain lease agreements.
In summary, nonprofit organizations should take the time to examine all their agreements to assess whether they have any embedded leases or other arrangements that are subject to lease accounting.
[1] See ASC 958-605-55-24.
[2] See ASC 958-605-24 and 958-605-25-2.
[3] See ASC 958-605-55-24.
[4] See ASC 842-20-30-3.
Written by Amy Duffin. © 2023 BDO USA, LLP. All rights reserved. www.bdo.com[CM1]
