The higher education world is becoming increasingly virtual, from completing financial aid applications on a mobile phone to offering full degree programs online. In the era of convenience, options and flexibility, the ability to evolve with the needs of those served is becoming key to the long-term future and stability of colleges and universities. Part of the equation of what the future holds is rethinking the need for “brick and mortar.” Own versus lease decisions are hardly a new concept but the increased need to rethink whether buildings should even be a part of the equation in the next few decades has made leasing far more appealing in recent years.
Leasing provides the benefit of an asset without high upfront cost or significant exit commitment. From an accounting perspective, operating leases have always been attractive by the virtue of being off-balance sheet commitments – no liability required to be reflected on the statement of net position, despite having a signed multi-year contract in place; no negative impact on key ratios; lighter impact on operations with lease payments being typically smaller in size than depreciation expense. Much of this is about to change, however, with the implementation of the new GASB Statement 87 Leases.
GASB 87 eliminates the distinction between operating and capital leases and requires a single application approach for all leases with terms longer than 12 months. The latter represents a significant change in the past treatment of operating leases. Residing solely in the footnotes to the financial statements in the past, institutions must now bring all of those operating lease liabilities on the statement of net position with a corresponding right-to-use (intangible) asset, starting with the effective date of the standard. GASB 87 is effective for reporting periods beginning after December 15, 2019 – calendar year 2020 or fiscal 2021 for most community colleges.
Recording operating lease liabilities on the balance sheet comes with two significant hurdles: determining lease term and discount rate. While it may appear that deciding on the lease term is not a complex matter (as lease terms are often clearly stated within the contract), renewal options are treated very differently under the new standard. Consider, for instance, a 15-year lease with two renewal options. Under current accounting standards, the term of the lease is 15 years. Once the renewal option is exercised, it becomes the new term of the lease. Under the new standard, the term of the lease may be considerably different – possibly 45 years! The premise of including the terms of all renewal options, together with the original lease term, is that institutions are sometimes more likely than not to exercise those renewal options. The standard puts the burden of proof on the lessee and provides specific criteria which a lessee can utilize to conclude whether or not it is likely to exercise the renewal option(s). Examples of those criteria include the nature of the lease payments (renewal options for lease payments at below-market rates are presumed likely to be exercised), lack of significant leasehold improvements (presence of such is an indicator that the renewal option would be exercised), historical experience, availability of alternative comparable lease options and low cost related to lease termination, among others. Options not likely to be exercised can be excluded when determining the final lease term. Determining the correct lease term will dictate the size of the liability that the institution will have to book on its statement of net position and time should be devoted to reviewing each material lease for renewal options and documenting management’s conclusion regarding whether or not those options are likely to be exercised.
The second, and more complex, matter in determining operating lease liabilities is discount rate. Such rates are inversely related to the size of the liability, with low discount rates driving high liability balances. The new standards requires lessees to use the rate implicit in the contract unless such rate cannot be reasonably determined. In such cases, the lessee can use its incremental borrowing rate at the commencement date of the leasing arrangement as an acceptable alternative. Incremental borrowing rate can be determined by looking to a newly acquired debt in the year of the lease commencement and should not be subsequently changed for the remaining duration of the lease (unless a significant change in the lease terms occurs which requires that the liability be reassessed).
While the lease standard is not effective for a few years, institutions should start preparing now to ensure smooth implementation in fiscal 2021 (calendar 2020). Here are a few practical steps to get started:
- Identify and inventory all lease arrangements. Those should include leases for space, equipment, vehicles, etc. Note that a contract no longer needs to explicitly be labeled a “lease” to require the application of GASB 87. As long as the new lease definition is met, effective in fiscal 2021, contracts would have to be accounted for as leases, even if previously they were simply expensed on a monthly basis. Example of contractual arrangements which were not previously thought of as leases but may meet the new definition include: energy contracts, arrangements for server space, information technology contracts, etc.
- Identify renewal options included in each lease arrangement. Determine whether the institution is more likely than not to exercise the lease renewal and document your conclusion in writing.
- Determine term for each lease, once a conclusion on the renewal options has been reached. Leases with a maximum possible term, at the commencement of the lease, of 12 months or less (including options to extend), are not required to be recorded as liabilities on the statement of net position as long as the institution makes the appropriate accounting election. If such election is made, ensure it is properly documented.
- Choose a discount rate for each lease liability and rate implicit in the contract or incremental borrowing rate.
- Calculate the total lease liability and determine possible effects on debt covenants and ratios. If failing debt covenants is a likely outcome because of adding the new lease liabilities to the statement of net position, consider reaching out to your debt holder early on. Discussing a waiver or amendment to the covenant definition or requirement is always easier when done in advance rather than after the institution has failed the covenant.
The new lease standard will likely have a significant impact on many institutions’ financial statements. Community colleges, especially those with substantial lease activity, should work closely with their independent auditors to ensure they are well prepared for the standard implementation.
Grace is a principal in the firm's Tax-Exempt division. She has a strong background serving colleges and universities, foundations, healthcare and human service providers, and philanthropic organizations. Grace has experience in a variety of engagements, ranging from financial statement and single audits to investment valuation and informational tax return preparation.