by John Heveron
It has been well publicized that accounting for leases is changing dramatically, but most of us are just getting our first hands-on experience with this change. The new rules are being implemented for calendar year 2022 and fiscal years ending in 2023.
This may raise a question about whether federal cost reimbursement will change.
An important first task is to determine whether you have operating leases or financing leases. In prior years we used the terms operating lease and capital lease. The new financing leases have similar characteristics to capital leases and, sometimes, the terms are used interchangeably.
Any lease that it is not a financing lease is an operating lease. A financing lease will have at least one of these characteristics:
- * ownership transfers to the lessee at the end of the lease,
- * the leased property can be purchased at the end of the lease and purchase is reasonably certain,
- * the length of the lease is for a major part of the useful life of the property,
- * the present value of the lease payments equals or exceeds substantially all of the value of the property, or
- * the asset is specialized and there is no practical alternative value for the leased property
If none of these characteristics exist, you have an operating lease and you will continue to record rent expense, so there shouldn’t be any adverse impact on your federal reimbursements.
None of these characteristics would typically exist for a facility lease (although that is possible).
If you do have a financing lease, you will be recording interest expense and also amortizing the asset (your right to the leased property). The amortization is uniform over the term of the lease, but the interest works like a loan, with more interest upfront, so expenses would be somewhat more initially than an operating lease, but not more than a prior capital lease under the old rules. Your federal reimbursements should not differ from a capital lease to a financing lease, but if an old operating lease is now characterized as a financing lease, your expenses and your reimbursements could increase slightly. Uniform Guidance and HHS Uniform Administrative Requirements both use generally accepted accounting principles (GAAP) as a starting point, so unless some modification is enacted, reimbursement for the accelerated expenditures should be permitted.
The big difference occurs on your balance sheet. All leases with a term of more than one year are capitalized (treated as assets) on your balance sheet. This is done by calculating the present value of the future lease payments including options that are likely to be exercised. Once that calculation is done you will record an asset that you might call “leased property”, or some other descriptive account, and a liability that you might call “lease liability”.
This raises several questions, including:
- * what about donated space? These rules don’t apply to donated space,
- * what about a below market lease rate? This could be a partial lease and a partial contribution, or just a good deal,
- * do these transactions get recorded retroactively or prospectively? An accounting option, which is probably the easiest way to implement the new reporting rules would be to record the asset and liability at the beginning of the current year in your financial statements or at the beginning of the lease if that is later,
- * what discount rate should be used to calculate the fair value? The rules say that if there is a rate implicit in the lease, we should use that, but that is rare so we can use a “risk-free rate of return” at the time the lease is recorded. For leases that have been in place but are recorded initially in your calendar year 2022 financial statements, you could use the federal bond rates. Federal bond rates at the beginning of 2022 were 1.34 % For 2 year bonds, 1.62% for 5 year bonds, and 1.83 For 10 year bonds,
- * should leases be broken out between short-term and long-term? Yes they should, and assets and liabilities related to operating leases and financing leases should be reported separately, and
- * Is there any other impact other than the extra work? Adding these assets and liabilities to your balance sheet could impact your compliance with loan covenants. Most bankers are well aware of this change, so if you believe your compliance with covenants will be affected, you should have a conversation with your banker.