Implementation Of GASB 87, Leases
By: Sam Thompson, CPA
In 2017, the Governmental Accounting Standards Board (GASB) issued GASB Statement (GASBS) No. 87, Leases (GASBS 87). GASBS 87 represents a significant change in accounting and financial reporting for leases by governments. After an 18-month postponement provided by GASB Statement No. 95, Postponement of the Effective Dates of Certain Authoritative Guidance, GASBS 87 is effective for fiscal years beginning after June 15, 2021. It is imperative for governments to proactively prepare prior to implementation to ensure a smooth and successful adoption.
GASBS 87 established a single model for lease accounting based on the foundational principle that leases are financings of the right to use an underlying asset. GASBS 87 defines a lease as a contract that conveys control of the right to use another entity’s nonfinancial asset as specified in the contract for a period of time in an exchange or exchange-like transaction. Any contract meeting this definition should be accounted for under the lease guidance, unless specifically excluded per the statement.
At the commencement of the lease term, the lessee should recognize a lease liability and an intangible right-to-use lease asset, for all leases not considered short-term or that transfer ownership of the underlying asset. The lease liability should equal the present value of payments expected to be made during the lease term, less any lease incentives. The lease asset should equal the initial measurement of the lease liability, plus any payments made to the lessor at or before commencement of the lease term and certain direct costs.
The lease liability is reduced over the life of the lease as payments are made. Payments made by the lessee include both principal and interest portions. The lease asset is amortized in a systematic and rational manner over the shorter of the lease term or the useful life of the underlying asset.
At the commencement of the lease term, the lessor should recognize a lease receivable, equal to the present value of lease payments expected to be received during the lease term, offset to a deferred inflow of resources, measured at the value of the lease receivable plus payments received at or before the commencement of the lease term that relate to future periods.
The lessor should recognize revenue (split between a base lease and interest component) in a systemic and rational manner over the term of the lease, from the deferred inflows of resources.
The lessors should not derecognize the asset underlying the lease. To the extent the asset underlying the lease is depreciable, the lessor should continue recognizing depreciation.
It is common for lease contracts to contain both lease and non-lease components. To the extent possible, non-lease components should be separated from lease components and accounted for separately. If the contract does not include separate prices for individual components or the prices provided seem unreasonable, the entity should use professional judgment to allocate the contract price.
Future lease payments should be discounted using the interest rate the lessor charges the lessee. In many contracts, the lessor’s rate is not explicitly stated. If the interest rate cannot be readily determined by the lessee, the lessee should use its own estimated incremental borrowing rate. This incremental borrowing rate will not be universal across all leases and should be determined based on relevant characteristics (e.g., lease term, commencement date) of each lease.
Lease Modifications and Terminations
Amendments made to a lease contract subsequent to inception should be considered a lease modification, except in instances in which the lessee’s right to use the underlying asset decreases. In such instances, the lease is considered to be a partial or full lease termination. In the event of a lease termination, the lessee should reduce the carrying values of the lease liability and lease asset; the lessor should reduce the carrying values of the lease receivable and deferred inflows of resources, with any difference recognized as a gain or loss. A lease modification that does not qualify as a separate lease should be accounted for by a lessee by remeasuring the lease liability and lease asset; the lessor should remeasure the lease receivable and adjust the related deferred inflows of resources.
GASBS 87 VS. ASC 842
While there are many similarities between GASBS 87 and its Financial Accounting Standards Board equivalent, ASC 842, there are key differences. The more significant differences are listed below:
- Lease types – Under ASC 842, leases are classified as either operating or finance leases. Under GASBS 87, no such distinction exists.
- Lease definition – GASBS 87’s definition of a lease requires the underlying contract meet the definition of an “exchange or exchange-like transaction,” whereas ASC 842’s lease definition specifies only the “exchange for consideration.” As such, a transaction in which consideration is exchanged, but done so at a value well below market rates, could meet the definition of a lease under ASC 842 but not under GASBS 87.
- Transfer of ownership provisions – GASBS 87 classifies contracts transferring ownership of the underlying asset to the lessee by the end of the contract without termination options not as a lease, but as a financed purchase of the underlying asset by the lessee and sale of the asset by the lessor. Per ASC 842, a contract transferring ownership meets the definition of a finance lease.
- Discount rates – GASB considered but ultimately rejected the use of a risk-free interest rate for discounting, as leases are not risk-free. ASC 842 provides lessees that are not public business entities with a practical expedient that allows them to make an accounting policy election to use a risk-free rate as the discount rate for all leases (later amended by Accounting Standards Update 2021-09 to allow for the risk-free rate election by asset class rather than at the entity-wide level).
- Substitution – Under GASBS 87 the right of substitution does not impact the control assessment for a lessee so long as the service capacity is unaffected. Under ASC 842,if the lessor maintains the right of substitution, and the lessee determines the lessor would benefit economically from the exercise of this right, then the contract is not considered a lease.
Effective Date and Transition
Governments should recognize and measure leases using the facts and circumstances that existed at the beginning of the earliest period restated. An exception exists in which lessors should not restate the assets underlying existing sales-type or direct financing leases. Any residual assets for those leases become the carrying values of the underlying lease assets.
Preparation for Implementation
Although implementation of GASBS 87 is primarily the responsibility of accounting personnel, successful implementation requires the involvement of the entire organization. Establishing and maintaining open and timely communication between all stakeholders is essential. A realistic and robust timeline, working backward from the target completion date, will help ensure adequate progress is made in advance of implementation. To ease the burden of implementation, governments should look for opportunities to use technology whenever possible. This may include acquiring lease accounting software or developing internal tools and programs.
Governments should perform a complete inventory of lease agreements (both as a lessee and lessor) and analyze each lease to determine if the lease meets the definition of a lease in accordance with GASBS 87. For those leases, governments should compile relevant data to complete the calculations necessary to record the lease liability and lease asset (lessee) or lease receivable and deferred inflows of resources (lessor), including (but not limited to):
- lease term (start and end dates, as well as any options to extend or terminate the lease)
- payment terms (amounts, frequency, fixed vs. variable)
- initial direct costs or ancillary charges paid at or before the commencement of the lease term
- discount rate charged by lessor to the lessee
- description of the underlying lease asset
- residual value guarantees
- purchase options
- termination penalties
When performing an inventory of all lease agreements, governments should be especially vigilant for embedded leases, or leases found in existing contracts not previously identified as such. Embedded leases are often found in service contracts, vendor or supply contracts, or other agreements that on their face do not indicate a potential lease component. As a best practice to help ensure a complete inventory of all leases, accounting personnel should reach out to other departments within the government (such as purchasing/procurement, real estate, facilities, and legal) and inquire about any known contracts potentially containing a lease component.
Additionally, governments should begin preparing new general ledger accounts and updating financial statement templates and preparing new required note disclosures.
ITEMS TO COMMUNICATE TO THOSE CHARGED WITH GOVERNANCE
By requiring all leases (except for those excluded under GASBS 87) to be accounted for on the face of the basic financial statements, certain lease assets and lease liabilities not reported previously are now recognized. Whereas in the past lessees and lessors differed significantly in presentation of operating leases, GASBS 87 establishes a single model for lease accounting that is the same for both lessees and lessors.
For lessees, the addition of lease liabilities and lease assets may significantly impact debt covenant calculations and greatly increase noncurrent liabilities. Management needs to educate those charged with governance on the impacts of GASBS 87 and to also frame the recognition of lease liabilities and assets in its proper context (mainly that such obligations and resources existed in prior periods but were not visible on the face of the basic financial statements.)
The accounting and financial reporting requirements of GASBS 87 requires governments to devote substantial time and resources to leases not only during implementation but in subsequent periods indefinitely. To ease the burden, governments should consider making an investment in lease accounting software.
In conclusion, the time to implement GASBS 87 is upon us. The changes to lease accounting and financial reporting represent some of the more significant changes to generally accepted accounting principles in recent years. Proper planning and coordination is of paramount importance to ensure successful adoption of GASBS 87.
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