Recognizing a lease liability before moving in
Scenario: An NFP entity enters a new lease contract with its landlord for the use of office space. Under the terms of the contract, the NFP can begin making improvements to the office space on Oct. 1, Year 1. The landlord will begin charging rent on Jan. 1, Year 2, which is when the NFP anticipates completing the improvements and occupying the space.
Q: On which date should the NFP record its right-of-use (ROU) asset and lease liability?
A: The NFP should recognize the lease liability on Oct. 1, Year 1 – the day that it is allowed access to the lease space by the landlord.
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Excerpts from FASB Accounting Standards Codification
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Master Glossary. Commencement date: The date on which a lessor makes an underlying asset available for use by a lessee.
ASC 842-10-55-19. In some lease arrangements, the lessor may make the underlying asset available for use by the lessee (for example, the lessee may take possession of or be given control over the use of the underlying asset) before it begins operations or makes lease payments under the terms of the lease. During this period, the lessee has the right to use the underlying asset and does so for the purpose of constructing a lessee asset (for example, leasehold improvements).
ASC 842-10-55-20. The contract may require the lessee to make lease payments only after construction is completed and the lessee begins operations. Alternatively, some contracts require the lessee to make lease payments when it takes possession of or is given control over the use of the underlying asset. The timing of when lease payments begin under the contract does not affect the commencement date of the lease.
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Key takeaway: In some cases, a landlord might grant a tenant access to the building prior to the lease’s contractual start date. For example, a landlord could grant access to the building prior to the tenant’s move-in date to allow the tenant to begin installing leasehold improvements or to begin moving in furniture.
From an accounting standpoint, a lessee must record the lease as soon as the lessee has access to the building – that is, as soon as the lessor “hands over the keys.” Because of this, the NFP entity could be required to record the lease liability before the contractual start date and even before lease payments are due.
Accounting for below-market rent (in-kind contributions)
Scenario: An NFP entity enters a new lease contract under which the NFP agrees to pay its landlord $5,000 per month for use of office space over the next five years. The current market rent for a similar property is $10,000 per month. The landlord is a frequent contributor to the NFP’s mission, which the NFP concludes is a contributing motivator for the below-market lease arrangement.
Q: How should the NFP account for the below-market nature of its lease arrangement with its landlord?
A: The NFP should account for the lease in accordance with ASC 842 based on the below-market lease payments it will make over the identified lease term. It also should record an in-kind contribution to reflect the nonmonetary contribution it is receiving from the landlord in the form of below-market rent.
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Excerpts from FASB Accounting Standards Codification
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ASC 842-20-30-1. At the commencement date, a lessee shall measure both of the following:
- The lease liability at the present value of the lease payments not yet paid, discounted using the discount rate for the lease at lease commencement (as described in paragraphs 842-20-30-2 through 30-4)
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The right-of-use asset as described in paragraph 842-20-30-5.
ASC 842-20-30-5. At the commencement date, the cost of the right-of-use asset shall consist of all of the following:
- The amount of the initial measurement of the lease liability
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Any lease payments made to the lessor at or before the commencement date, minus any lease incentives received
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Any initial direct costs incurred by the lessee (as described in paragraphs 842-10-30-9 through 30-10).
ASC 958-605-55-24. Unconditional promises to give the use of long-lived assets (such as a building or other facilities) for a specified number of periods in which the donor retains legal title to the long-lived asset may be received in connection with leases or may be similar to leases but have no lease payments. For example, an NFP may use facilities under a lease agreement that calls for lease payments at amounts below the fair rental value of the property. In circumstances in which an NFP receives an unconditional promise to give for a specified number of periods, the promise should be reported as revenue and as a contribution receivable for the difference between the fair rental value of the property and the stated amount of the lease payments. In other words, if a donor promises that the NFP can use a facility for 10 years, the NFP has received a multiyear promise to give and should report the fair value of that promise as a contribution with a donor-imposed restriction in Year 1. Amounts reported as contributions shall not exceed the fair value of the long-lived asset at the time the NFP receives the unconditional promise to give. The contribution receivable may be described in the financial statements based on the item whose use is being contributed, such as a building, rather than as contributions receivable.
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Key takeaway: NFPs might receive in-kind contributions in the form of discounted (below-market) rent. Although this contribution isn’t in the form of cash, the guidance still requires the contribution to be recognized by NFP entities at fair value.
As explained in ASC 958-605-55-24, an NFP entity should recognize contribution revenue and a contribution receivable “for the difference between the fair value rental of the property and the stated amount of the lease payments.” When recognizing the contribution, the NFP entity should consider the need to report the contribution as donor-restricted.
Accounting: The entity records its initial lease liability and ROU asset based on the contractual lease payments; it records the contribution revenue and contribution receivable based on the difference between the fair rental value for the lease and the amounts paid by the NFP entity under the lease terms.
Over the term of the lease, the NFP recognizes periodic lease expenses equal to the fair value rental for the leased property and credits the amount of cash paid for that period. The NFP recognizes the difference between the fair value rental and the cash paid as a reduction of the contribution receivable.
For a detailed explanation of Day 1 and Day 2 accounting and sample journal entries, refer to the Appendix.
Crowe observation: Under Topic 842, the lease term includes renewal periods that an entity is reasonably certain to exercise. Therefore, the amounts of the lease liability and ROU asset initially recognized include lease payments for any renewal periods reasonably certain to be exercised, even if the entity has not formally exercised these periods.
In contrast, the amount of the contribution revenue and related contribution receivable recorded is based on the amount of the contribution that is unconditional. Given the difference in recognition requirements for leases and contributions, NFP entities should ensure appropriate amounts are recorded for both items.
Fully donated and $1 leases
Scenario: An NFP entity enters a new lease contract under which the NFP has the right to use office space over the next five years in exchange for a de minimis amount of rent ($1 per year). As in the previous scenario, the landlord is a frequent contributor to the NFP’s mission, which the NFP concludes is a contributing motivator for the $1 lease arrangement.
Q: How should the NFP account for this $1 lease?
A: The $1 lease is substantively a fully donated lease and is therefore accounted for entirely as a contribution in accordance with Subtopic 958-605.
Crowe observation: Under Topic 842, a contract must involve the exchange of consideration for use of the leased asset to be considered a lease. Landlords donating the use of an asset might structure a lease with a minimal amount of rent – for example, $1 per year – with the aim of giving the contract commercial substance.
While lease payments can be discounted significantly, we believe a $1 lease does not constitute meaningful consideration to be considered a lease for accounting purposes.
Accounting: Accounting for the $1 lease should follow the in-kind contribution guidance in ASC 958-605-55-24. That is, the NFP entity would recognize contribution revenue and a contribution receivable for the difference between the fair rental value of the property and the stated amount of lease payments.
Early terminations versus early “terminations”
Scenario: Looking to shift to a more remote work model for its employees, an NFP entity negotiates with its lessor and executes an amendment to terminate its lease early, freeing it to find a smaller location. The revised lease reduces the remaining lease period to three months after the amendment date and requires the NFP to pay a termination penalty equal to three months’ rent immediately.
Q: How should the NFP account for the early termination?
A: The early termination as described in this scenario is accounted for as a lease modification, not a lease termination – an important distinction given the difference in accounting treatment between the two.
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Excerpts from FASB Accounting Standards Codification
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842-20-40-1. A termination of a lease before the expiration of the lease term shall be accounted for by the lessee by removing the right-of-use asset and the lease liability, with profit or loss recognized for the difference.
Master Glossary. Lease modification: A change to the terms and conditions of a contract that results in a change in the scope of or the consideration for a lease (for example, a change to the terms and conditions of the contract that adds or terminates the right to use one or more underlying assets or extends or shortens the contractual lease term).
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Key takeaway: What a landlord and tenant might describe as a lease termination in name doesn’t necessarily qualify as a lease termination for accounting purposes. In accordance with the GAAP definition, a lease modification includes any change in the scope of the lease, or any change that shortens the contractual lease term. Practically, this means that many early “terminations” would be accounted for as lease modifications, since they truncate but do not immediately end the lease term. For lease termination accounting to apply, the lease must be both fully and immediately terminated.
Accounting: In the event of an early “termination” that is not full and immediate – that is, a lease modification – an entity must reassess the lease classification based on the modified terms and remeasure the lease liability using the modified lease payments and an updated discount rate.
The adjustment to the ROU asset is dependent on the nature of the modification – in particular, whether there is a change in scope. Importantly, a shortened lease term is not considered a reduction in scope. If there is a reduction in the scope of the lease (for example, the amendment immediately terminates part, but not all, of the existing lease), the entity must de-recognize a proportionate amount of the ROU asset, as well as a corresponding gain or loss. If there is not a reduction in scope, the entity adjusts the ROU asset by the amount of the change to the lease liability.
In a lease modification, any termination penalty paid is included in the consideration to be allocated over the remaining lease term. That is, no part of the termination penalty would be recognized upfront. In contrast, in a lease termination, a termination penalty would be recognized as part of the gain or loss upon immediate termination.
Sublease considerations
Scenario: With the ongoing shift to a more remote work environment, an NFP looks to reduce its real estate footprint. To accomplish this, and as permitted by its lease contract, the NFP elects to sublease part of its leased space to a third party for the remainder of its lease term.
Q: When a lessee subleases part of its leased space, what impact can this have on the original (head) lease?
A: A sublease gives rise to several accounting considerations, including potential changes to the term of the head lease and possible impairment considerations. The NFP entity should consider the following factors:
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Lease term of the head lease
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A sublease term that exceeds that of the head lease would require the NFP to extend its head lease – thereby making it reasonably certain that the NFP will exercise subsequent renewal options. If the NFP’s original assessment of the lease term for the head lease did not include those renewal options, a lease reassessment event would be triggered.
Refer to ASC 842-10-35-1 and 55-28.
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Lease classification of the sublease
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The NFP must assess whether the classification of the sublease affects its head lease. Assume here that the head lease is classified as an operating lease and the NFP is not relieved of its primary obligation under the original lease.
If the sublease is classified as an operating lease, the NFP continues to account for the head lease as it had prior to the commencement of the sublease.
In contrast, if the sublease is classified as a sales-type or direct financing lease, the NFP must de-recognize the ROU asset associated with the head lease. The NFP continues to account for the lease liability associated with the head lease as it had prior to the sublease inception. However, it must assess the net investment associated with the sublease for potential impairment.
Refer to ASC 842-20-35-14.
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Lease impairment
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Per ASC 360, long-lived assets (including ROU assets) must be tested for impairment at the asset group level – that is, the lowest level for which identifiable cash flows are largely independent of the cash flows of other groups of assets and liabilities. To identify asset groupings, an entity must consider company-specific operating characteristics, including the interdependency of revenues and costs.
The new cash inflow that the NFP receives from the sublease can create a new, distinct asset group if the sublease covers a portion of the property leased under the head lease – for example, a couple of floors or one wing of a leased building. In this scenario, the sublease introduces cash inflows associated with a portion of the leased property that are independent of the remainder of the leased property, for which no cash inflows exist.
Depending on the consideration that the NFP receives for the sublease, it might need to assess the asset group for impairment – specifically, whether the consideration received by the NFP for the sublease is less than the consideration that the NFP pays for that component of the head lease. This scenario could indicate that the carrying amount of the head lease ROU asset is not recoverable.
Refer to ASC 360-10-35-17 and 360-10-35-23 through 25.
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Conclusion
NFP entities can face distinct challenges when it comes to the lease accounting standard, whether from the interaction of not-for-profit and lease accounting guidance or from other scenarios unique to NFP entities. It’s important for NFPs to carefully examine all aspects of their lease-related scenarios for circumstances that could affect their accounting.
Appendix
Accounting for below-market rent
Day 1
On Day 1, the NFP entity records the lease liability based on the present value of lease payments to be made throughout the lease term. It records the ROU asset in the amount of the lease liability, any upfront lease payments, and any initial direct costs, less any lease incentives.
Concurrently, the NFP entity records the contribution receivable and contribution revenue based on the implied value of the donated portion of the lease (the in-kind receivable). The entity also must assess whether the in-kind contribution is donor-restricted, conditional, or unconditional for classification in the statement of net assets.
1A. Record present value of lease liability and any upfront lease payments and any initial direct costs, less any lease incentives; and record corresponding ROU asset.
Dr. ROU asset
Cr. Lease liability
Cr. Cash prepayment (if any)
1B. Record present value of fair value of in-kind contribution.
Dr. Contribution receivable
Cr. Contribution revenue
Day 2
In each subsequent payment period, the entity records the cash lease payments, lease expense, and amortization of the lease liability and ROU asset normally in accordance with Topic 842.
To account for the in-kind contribution component of the rent, the entity must book two sets of entries each period. First, the entity records remaining lease expense (to reflect lease expense at fair rental value) and a credit to the contribution receivable for the current period in undiscounted amounts. The entity also records an entry to reflect the amortization of the present value discount, recorded as contribution revenue.
2A. Record periodic rent in accordance with Topic 842.
Dr. Lease expense
Dr. Lease liability
Cr. Cash
Cr. ROU asset
2B. Record lease expense and use of contribution receivable in undiscounted amounts.
Dr. Lease expense
Cr. Contribution receivable
2C. If applicable, record release of restricted net assets.
Dr. Net assets released, net assets with donor restrictions
Cr. Net assets released, net assets without donor restrictions
2D. Record amortization of present value discount, offsetting undiscounted amount of contribution receivable recognized in entry 2B.
Dr. Contribution receivable
Cr. Amortization of present value discount (contribution revenue)
