Understanding the Discount Rate: FASB Lease Accounting Standard

By | FASB, Nonprofit | No Comments
people looking at a laptop on a desk which has a graph

In November 2021, the FASB board rejected an extension request for the effective date of the new lease accounting standards. That means that the time is now imminent for nonprofits to adopt these requirements.

Your organization’s discount rate is an important item to both understand and determine as you begin the implementation of Accounting Standards Update No. 2016-02 (Topic 842). The discount rate impacts both lease classification and liability.

Importance of the Discount Rate

To determine lease liability, the discount rate is applied to all future lease payments. This is needed to calculate the present value of lease payments. Because a right-of-use asset is based on lease liability, the discount rate will impact the initial value of a right of use asset.

Determining Lease Classification

There are two lease classifications:

  • Finance lease
  • Operating lease

To determine the classification of a lease, consider whether the present value of lease payments is equal to or almost all of the fair value of the asset.

Now you can see how the discount rate can impact the income statement and the balance sheet. It depends on how you determined the lease classification.

Determining Discount Rate

For lessees, the discount rate is the rate stated in the lease. If the rate cannot be readily determined, you can use either the incremental borrowing rate or the risk-free rate.

What if a lease needs to be remeasured? Then a new discount rate is established at remeasurement.

You Can Elect the Risk-Free Rate

To make things easier, entities that are not public may make an accounting policy election to adopt a risk-free discount rate as their discount rate instead of the incremental borrowing rate. This rate should be applied using a term comparable to the lease term based on the earliest date the lease is presented in the financial statements.

However, if the rate is readily determinable from the lease agreement, that rate should be used instead of the risk-free rate. The risk-free rate can only be used when the rate implicit in the lease is not readily determinable. You can find risk-free rates on the Treasury website.

The bottom line: the rate to be used must be the one that best reflects the accuracy of the transaction and be easily determined. Nonprofits should create various financial what-if scenarios to see how each discount rate affects their income statement and balance sheet. Then choose the one that makes the most sense from both an accuracy and transparency situation as well as what makes the most sense for their financial needs.

Welter Consulting can assist you with this determination and other questions—contact us for an appointment.

Welter Consulting bridges people and technology together for effective solutions for nonprofit organizations. We offer software and services that can help you with your accounting needs.

2022 Updates to GAAP Standards

By | Accounting, FASB, Nonprofit, Uncategorized | No Comments

person using calculator at desk with spreadsheetsWe typically report on changes to GAAP standards as they arise. This year has been a particularly active one with numerous changes impacting leases, gifts in kind, reference rate reform, and costs associated with cloud computing. Below are the highlights; for specifics, see the linked information.

Topic 842: Lease Standards

FASB 842

Although the standard was presented six years ago, it must now be fully implemented for all entities reporting on a GAAP basis for calendar year 2022 and fiscal years ending in 2023. The accounting standards for lessors has not changed. However, there are several changes for lessees which must be included on the balance sheet.

Lessees’ commitments and rights can now be recognized on the balance sheet as a liability for the total payments made throughout the term of the lease. The “right to use” the asset can also be recognized as a liability on the balance sheet.

Lease classifications have also changed. Instead of operating and capital leases, they are now to be classified as operating or financing.

Topic 958: Gifts-In-Kind

Update 2020-07

Effective for all entities for calendar year 2022, reporting after June 15, 2021, there are changes to reporting gifts-in-kind (GIK). The standard to determine whether something is a gift hasn’t changed, but the reporting requirements have been updated.

You will need to disclose specific information for each category:

  • Your organization’s policy for gifts-in-kind.
  • Potential donor-imposed restrictions on GIK.
  • How you arrived at the value determination and fair market value.
  • Whether GIK was monetized or utilized.

For more information, please read: An Overview of Gifts—In-Kind

Reference Rate Reform

Topic 848

ASU 2020-04

LIBOR, or the London Inter-Bank Offer Rate, has been the norm since the 1980s as a reference rate for interest. Now, however, it is being retired as a point of reference. This change is effective March 2022 through December 2022 and impacts many loans, leases, and derivatives.

The current GAAP requirement is that entities analyze whether a change in interest rate for a loan is a debt modification or debt extinguishment. This is time-consuming and can be quite complicated. Refer to ASU 2020-04 for helpful tips to make the transition easier and smoother.

Cost Associated with Cloud Computing

ASU 2018-15 Subtopic 350-40

This change is effective for nonpublic entities for the calendar year 2021 and fiscal years ending in 2022. Entities may choose to apply it either prospectively or retrospectively.

Cloud computing software is used on a licensing arrangement. Either the license is a subscription or a license. Licenses are usually recorded as an intangible asset for the software license and a liability for remaining payments due. For subscription-based cloud software, it is expensed as incurred.

For more information on this topic, read: New FASB Cloud Computing Standard Reduces Complexity.

Need Help Navigating GAAP Changes?

If you’d like some assistance navigating these GAAP changes, we’re here to help. We can also assist you with choosing the right nonprofit software to make accounting, including following accepted best practices, and implementing changes to your general ledger and overall accounting software.

Welter Consulting bridges people and technology together for effective solutions for nonprofit organizations. We offer software and services that can help you with your accounting needs. Please contact Welter Consulting at 206-605-3113 for more information.

Making Functional Expense Classifications for Nonprofits Useful for Public Trust

By | Accounting, FASB, Nonprofit | No Comments

Under FASB ASC 958, nonprofits are required to classify functional expenses by category. Most nonprofits choose to do this in one of three ways:

  1. As a separate statement of functional expenses
  2. As a schedule in the notes of their financial statement
  3. Within the statement of activities itself

All nonprofit organizations should classify functional expenses according to their nature and category. Doing so, and sharing the information publicly in the annual report, helps build public trust by making all expenses transparent and easy to understand.

The following tips will help you make your nonprofit’s functional expenses classifications useful for both your organization and for building trust with the public.

Four Tips for Functional Expense Classifications

  1. Use common sense when determining the number of natural categories.

Some nonprofits seem to believe that the more natural categories they include, the better. The opposite is true: less is more. Too many categories can confuse the public and give the appearance of wastefulness.

U.S. GAAP does not specify a particular quantity of expense categories that must be included in the report of functional expenses, so it’s truly up to your organization on how many you’d like to include. Given that the expenses are often depicted in a table or on one page, too many expense categories will be hard to read and understand. Choose a level of detail that paints an accurate picture of your organization’s activities.

  1. Let your program activities tell the story.

Carefully consider which programs to disclose separately. Best practices for nonprofit financial accounting and reporting suggest disaggregating the major classes of program services to meet functional expense reporting requirements. In this way, your program’s finances can tell the story of how and why expenses are incurred.

  1. Review how employee services are classified.

Some expenses such as human resources, accounting, and other internal employee-related services should be reported as general administration and management because these activities benefited the organization as a whole. However, some nonprofits dislike linking all service-related internal positions to this category; it tends to “bloat” the amount, increasing the percent of funds allocated to overhead, which the public may perceive as inefficiencies or “too much money” spent on management needs. Review your allocations and consider how much of a given employee’s time is truly spent working for the good of the whole organization or for a particular program. If it can be clearly argued that an accountant is fully dedicated to a program line funded by a grant, for example, then their salary may be apportioned to that fund rather than general admin. There are many gray areas, so take this as a general guideline, and be thorough in your review of all your expense categories.

  1. Examine your allocation methodology.

One of the reporting requirements is that the allocation methodology is disclosed in your financial statements. Ask yourself, “Would someone looking at this expense understand our rational? Does it sound reasonable?” Because all the information and the methodology are disclosed to the public, it must meet the litmus test of both “is it reasonable” and is it “understandable.”

Clear Communication Improves Public Trust

Functional expense allocation is often tricky, and organizations tend to err on either side—too much disclosure or too little. A review of your current expense allocation and methodology and updating it to match current needs may help the public better understand how funds are spent and how your nonprofit handles its finances.

Welter Consulting

Welter Consulting bridges people and technology together for effective solutions for nonprofit organizations. We offer software and services that can help you with your accounting needs. Please contact Welter Consulting at 206-605-3113 for more information.

Common Functional Expense Allocation Errors—and How You Can Avoid Them

By | Accounting, FASB, Nonprofit | No Comments

One of the most important questions potential donors ask themselves when reviewing nonprofit financials is how an organization uses it funds. Donors want to know that a nonprofit uses them wisely and puts most of its money towards its programs. An analysis of expenses by nature and function can tell a compelling story to potential donors and make it clear that your nonprofit is a responsible steward of its funds.

But there are several common functional expense allocation errors that occur among many nonprofits. Is your organization making these mistakes?

7 Functional Expense Allocation Mistakes

  1. No expense allocation methodology: Now that GAAP requires nonprofits to disclose the methods they use to allocate costs among programs and various support functions, it’s more important than ever to ensure that you have a reasonable allocation method. It’s assumed that nonprofits will each choose their own allocation method. What’s important is that the method makes sense (is considered “reasonable”) and that it is applied consistently. Lack of a documented expense allocation methodology is a common mistake that is easily rectified.
  2. Incorrectly classifying management and general expenses: GAAP rules (FASB ASC 720-958-45-7) stipulate that various expenses should be allocated to management and general expenses. This includes payroll, human resources, and accounting costs. In years past, nonprofits had more leeway to allocate these expenses. If your organization hasn’t updated its allocation guidelines, now’s the time to fix this common mistake.
  3. Allocating too few costs to programs: Another common error is not allocating enough costs to actual programs. An example is an accounting professional whose salary expense is allocated to management, but they provide 100% of support to a particular program. In that case, their costs should be allocated to the program instead of to the overall payroll budget.
  4. Not considering joint costs: If an activity supports multiple purposes, consider allocating it as a joint cost. FASB ASC Subtopic 958-720, Not-for-Profit Entities-Other Expenses describes the reporting requirements. Creating a systematic and reasonable basis for allocating joint costs and applying it consistently helps rectify this error. Consider and choose from among several allocation methods, too, such as the physical-units method, the relative-direct-costs method, and standalone method.
  5. Providing the appropriate level of detail: It can be challenging to provide the appropriate level of detail for the natural component of expenses in the functional expense analysis. To find the best level of detail, consider the needs of your audience. What do they want and need to know? Find a happy medium between disclosing too much and too little information.
  6. Not allocating fundraising expenses: Check that the salaries allocated to fundraising expenses are reasonable. Many organizations fail to allocate fundraising expenses appropriately. Ask yourself if the amount you are currently allocating is reasonable. You may need to make some adjustments.
  7. Misclassifying investment-related activity: Under current GAAP requirements, direct internal and external investment related expenses should be netted on the statement of activities with the investment return. Based on the new presentation requirements, such expenses should be omitted from the functional expense analysis.

Professional Judgment Is Vital

Nonprofit accounting professionals must use their judgment when considering functional expense allocation. Knowing the common errors and keeping them in mind when reviewing your organization’s financials can help you make prudent decisions that are in the best interests of your nonprofit.

Welter Consulting

Welter Consulting bridges people and technology together for effective solutions for nonprofit organizations. We offer software and services that can help you with your accounting needs. Please contact Welter Consulting at 206-605-3113 for more information.