Effective for fiscal years beginning January 1, 2020, a new approach for accounting and reporting leases will be required for state and local governments under GASB Statement 87, Leases. This standard, which will be applied retroactively, establishes a single model for the accounting of leases based on the principle that leases are financings of the right to use the underlying asset. The previous standard was considered by many critics to allow leases to be structured in ways that avoided reporting the economic reality of the transaction. GASB deemed the new standard necessary to ensure that the reporting of lease agreements was consistent with the conceptual framework of assets and liabilities as described under GASB Concepts Statement 4, Elements of the Financial Statements, which was issued in 2007.
Lease Accounting Prior to GASB Statement 87
Prior to the issuance of GASB Statement 87, the accounting of leases in governmental accounting followed FASB Statement of Financial Accounting Standards (SFAS) 13, Accounting for Leases, which centered on the classification of the nature of the lease as either operating or capital. Governments were quick to comply with SFAS 13 due to the encouragement of the federal government revenue sharing program, which required an audit for those entities that received more than $25,000 in federal funds, and of the bond rating agencies (Robert W. Parry and Stuart K. Webster, “City Leases: Up Front, Out Back, In the Closet,” Financial Analysts Journal, Sept. 1, 1980, http://bit.ly/3cWjoc2). Governments that were lessors also had to determine whether the lease was a capital lease (i.e., financing) or operating lease. Capital leases required the lessee to recognize a capital asset and a long-term liability (value based on the present value of the future minimum payments), while operating leases only required the lessee to record the lease payments as expenses in the period they were incurred.
The separating of leases into operating and capital based on arbitrary percentages was widely criticized for creating an artificial distinction, even though the both types of leases resulted in a long-term obligation that required future payments. In 2005, the SEC estimated that companies possessed $1.25 trillion in off–balance sheet, noncancelable lease obligations and recommended that FASB, along with the IASB, address the inconsistencies in the lease accounting standards [Report and Recommendations Pursuant to Section 401(c) of the Sarbanes-Oxley Act of 2002 on Arrangements with Off-Balance Sheet Implications, Special Purpose Entities, and Transparency of Filings by Issuers, 2005, http://bit.ly/2tnZ3Eq].
In 2016, after a 10-year joint project between FASB and the IASB, FASB issued Accounting Standards Update (ASU) 2016-02, Leases (Topic 842), which required for-profit entities to recognize lease assets and liabilities on the balance sheet after December 15, 2018, for public companies and December 15, 2019, for privately held companies. Many observers expected GASB to carbon-copy FASB’s new guidance on leases; however, it did not. Instead, it elected to treat all leases as financing leases, with no distinction between operating and financing classifications. GASB did, however, closely monitor the FASB/IASB lease project, and met periodically with FASB to discuss issues and decisions related to the guidance.
GASB Statement 87 Lease Accounting
Under GASB Statement 87, a lease is a “contract that conveys control of the right to use another entity’s nonfinancial asset (the underlying asset) as specified in the contract for the period of time in an exchange or exchange-like transaction.” It is based on the principle that “all leases are financings of the right to use a capital asset.” Therefore, all leases are accounted for as financing leases unless they fit into one of the provided exceptions (Exhibit 1).
GASB Statement 87 Exceptions
- Intangible assets (e.g., software licenses)
- Sales with leasebacks for nominal amounts
- Arrangements with blended components
- Concession service and cost-recovery arrangements
- Leases of inventory
- Other (e.g., mining rights, biological assets)
Upon inception of the lease, the lessee (i.e., government) recognizes a long-term liability equal to the present value of future lease payments and an intangible asset that represents the right to use the asset being leased. The intangible asset value on the government’s financial statements should equal the long-term liability lease amount plus any other costs, such as prepayments to the lessor or incidental charges (e.g., installation costs) incurred in the lease transaction.
The lessor recognizes the long-term lease receivable (measured the same way as the lessee measures the long-term lease liability) and a deferred inflow of resources. A major change in GASB Statement 87 for lessors requires them to continue to recognize the capital asset on their balance sheet; prior accounting standards required lessors to derecognize the lease if it was considered a capital lease. Furthermore, depreciation expenses will be recognized by the lessor, not the lessee, under the new accounting guidance.
As lease payments are made, the lessee will reduce the lease liability (principal portion of payment) and record the accrued interest payable. In addition, the lessee will amortize expense on the intangible asset recognized upon the inception of the lease. As the lease payments are received, the lessor will reduce the related long-term lease receivable and accrued interest receivable. The lessor should also recognize the lease revenue in its income statements over the term of the lease in a systematic and rational manner. Note disclosures for both the lessee and lessor are basically the same as found under previous lease accounting guidance.
Effects of GASB Statement 87
The biggest change in the new leasing standard with respect to state and local governments is that retroactive application to existing leases is now required. In contrast to the prospective approach for tax abatements taken by GASB Statement 77, governments will have to consider all leasing arrangements as of the date of implementation for GASB 87 and not at the inception of the lease.
Another significant effect of the new standard is that lease accounting will be quite different in for-profit entities as compared to most not-for-profit entities, including state and local governments. For example, not-for-profit hospitals and universities will follow the FASB guidelines for lease accounting, while governmental hospitals and universities will follow the GASB guidelines. The new standard should, however, result in more accurate financial analysis, as applying the single accounting approach to all leasing arrangements should eliminate the “bright-line standard” transaction structuring for those lease agreements that exceed one year.
The new standard will also have an impact on the financial statements of the lessee (Exhibit 2), which previously did not recognize either long-term assets or liabilities related to the leases if they were considered operating leases. The statement of net assets will have new asset and liability accounts, although overall net position will not be affected, due to offsetting assets and liabilities. The statement of activities will now include an amortization expense. Finally, note disclosure will be similar to current debt note disclosures for lessees (i.e., governments), which should provide descriptions of the leasing arrangements as well as inflows of resources for the period.
GASB Statement 87 Effects on Financial Statements
Statement of Net Assets
New assets and liability accounts
Statement of Activities
Notes to Financial Statements
Disclosure of lease terms
From a financial ratio perspective, the recognition of lease liabilities will negatively impact debt ratios. Debt limits under current constitutional or statutory provisions must be considered, as governments must remain in compliance. The potential for balance sheet misstatement increases if not all leases are properly recorded. Systems and business processes may also have to change as a result of the new lease standard, including the retraining of staff and investment in lease accounting software.
A New Era Is Here
It is important for both governmental accounting professionals and public accounting firms that audit state and local governmental financial statements to properly prepare for GASB Statement 87. The standard is now in effect for all reporting after December 15, 2019, and there are many things that must be done in order to ensure that all lease agreements are properly reflected in the financial statements (Exhibit 3).
GASB Statement 87 Action Items
- 1) Gain an understanding of the new standard
- 2) Review all lease contracts and other contracts that may contain leases
- 3) Evaluate systems and internal controls
- 4) Determine whether lease contracts have nonlease components
- 5) Review amounts used to calculate lease liability
- 6) Evaluate lease classifications and assumptions
- 7) Review lease disclosures
- 8) Communicate with stakeholders about new leasing standards and how they will affect the overall financial reporting process
In September 2018, the Government Finance Officers Association (GFOA) issued an advisory, “Accounting for Leases,” that recommends several key considerations for governments as they implement the new accounting and financial reporting requirements for leasing arrangements under GASB Statement 87 (http://bit.ly/2vTxw51). These include ensuring that all accounting and audit staff members understand the new standard and that contracts and calculations are thoroughly reviewed. Systems and internal controls will need to be evaluated to ensure that all leases are properly identified and recorded, including lease classifications and assumptions.