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The New Lease Standard and Its Implications on NMTC World

Published by Nisreen Karkotli on Friday, January 5, 2024

Journal Cover January 2024   Download PDF

What are the implications of the new Financial Accounting Standards Board (FASB) Accounting Standards Codification 842 (ASC 842) on entities involved in new markets tax credit (NMTC) transactions?

The NMTC incentive aims to attract private investors to make equity investments in low-income communities in exchange for tax credits against their federal income tax. This happens through community development entities (CDEs) which select qualified active low-income community businesses (QALICBs) to receive the funds for investment. The credit is claimed by the investor over a period of seven years. Such investments in QALICBs must comply with Internal Revenue Code Section 45D. The CDEs are usually partnerships with income passing through to the investor member. 

Financial reporting helps NMTC entities to show and maintain compliance with the IRC Section 45D regulations. With the world of accounting constantly evolving, the new lease accounting standard has far-reaching implications for various entities, including those involved in NMTC transactions. Following is a look at the new lease standard, its key provision and the implications on the accounting for NMTC entities. 

The New Lease Standard: A Brief Overview

The new lease standard became effective for public companies for reporting periods that started after Dec. 15, 2018. For private entities, it became effective Jan. 1, 2022. Under ASC 842, lessees are now required to recognize virtually all leases on their balance sheets. This represents a significant shift from the previous standard, ASC 840, where operating leases were not required to be recognized on the balance sheet, resulting in off-balance sheet financing. ASC 842 introduces the concept of right-of-use (ROU) assets and lease liabilities. Lessees must recognize ROU assets and lease liabilities for all leases with a term of more than 12 months, regardless of whether they are classified as finance or operating leases. 

Implications for NMTC Entities

NMTC entities play a crucial role in financing projects in underserved communities. Specifically, QALICBs often enter lease agreements as part of their operations. Thus, the implementation of ASC 842 has several implications for QALICBs. 

Impact on Financial Statements 

ASC 842 requires lessees to recognize both ROU assets and lease liabilities on their balance sheets. This change can impact the financial reporting of QALICBs, potentially affecting their compliance with debt covenants.

Enhanced Transparency

One of the key objectives of ASC 842 is to improve transparency in financial reporting by eliminating off-balance sheet financing. As a result, QALICBs are now required to provide a more accurate representation of their financial position. This increased transparency may be viewed positively by investors and the CDEs, as it provides a clearer image of the entity’s lease obligations.

Lease Classification

Under ASC 842, lessees are required to classify leases as finance or operating leases. The classification impacts how the lease expense is recognized on the income statement and the presentation of cash flows on the statement of cash flows. QALICBs must carefully assess lease agreements to determine the appropriate classification, as this can affect their financial reporting. This poses an accounting challenge to QALICBs.

NMTC Considerations

While ASC 842 has no direct or significant implications on the NMTC allocation process, the requirement from the lessees to provide detailed disclosures related to their lease agreements adds a layer of work that the QALICBs need to do to comply with ASC 842.

Challenges and Considerations

The implementation of ASC 842 presents several challenges for QALICBs: 

Identifying and evaluating lease agreements within complex financing structures can be challenging. QALICBs must carefully review all contractual arrangements to determine which agreements meet the criteria for lease recognition under ASC 842.

Determining the lease term and assessing renewal options can be complex. QALICBs may need to make assumptions about the likelihood of renewals and the exercise of purchase options, which can impact the measurement of lease liabilities and ROU assets.

Compliance with ASC 842 may require QALICBs to invest in new accounting systems and processes to accurately record and report lease-related information. This can involve significant time and resources.

The introduction of ASC 842 brought about significant changes in lease accounting, impacting various entities, including those involved in NMTC transactions. QALICBs that resemble the investment pool of the CDEs must adapt to these changes by carefully assessing lease agreements, understanding the implications on their financial statements and debt covenants, and ensuring compliance with program requirements. While the transition to ASC 842 presents challenges, it also offers an opportunity for increased transparency and improved financial reporting in the world of NMTC financing. 

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