In June 2017, the Governmental Accounting Standards Board (GASB) issued Statement No. 87, Leases (Statement 87). Statement 87 was originally to be implemented by governmental entities for fiscal years beginning after December 15, 2019, but with the unfortunate onset of the COVID-19 pandemic, Statement 87 was postponed until fiscal years beginning after June 15, 2021 and all reporting periods thereafter. The GASB believes that Statement 87 increases the usefulness of governments' financial statements by requiring recognition of certain lease assets and liabilities for leases that previously were classified as operating leases.
WHAT DOES STATEMENT 87 INVOLVE?
Prior to Statement 87, leases were classified as either operating or capital, based on a four-factor test. Operating leases were merely expensed as contractual payments were made, and capital leases were actually capitalized, and amortized, along with recognizing a related long-term liability. Now, Statement 87 establishes a single model for lease accounting based on the foundational principle that leases are financings of the right to use an underlying asset, which eliminates the classifications of operating and capital leases, and the four-factor test. In addition, Statement 87 fundamentally changes lease recognition, measurement, and related disclosures for both lessees and lessors.
The major changes required by Statement 87 are as follows:
- Leases are to be classified as “short-term”, “contracts that transfer ownership”, and “all other”.
- Leases that extend beyond 12 months will have a balance sheet impact on both the lessee and lessor.
- For leases other than short-term leases and contracts that transfer ownership, the lessee will recognize an intangible right to use lease asset, and the lessor will continue to depreciate and account for the lease asset.
- Financial statement disclosures and schedules will be required for contracts that transfer ownership and non-short-term leases.
- There will be no disclosure requirement for short-term lease outflows.
Definition of a Lease
A lease is defined 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. In order to determine whether control exists, your governmental entity should assess whether it has both the ability and right to use the nonfinancial asset. Examples of nonfinancial assets include buildings, land, vehicles, and equipment. Any contract that meets this definition should be accounted for under Statement 87, unless specifically excluded by the Statement. Statement 87 does not apply to the following nonfinancial assets:
- Intangible assets, including mineral rights, patents, software, etc.
- Biological assets
- Service concession arrangements (addressed in GASBS No. 60)
- Assets financed with conduit debt
- Supply contracts such as power purchase agreements
- Transfer of an asset to the governmental entity (the lessee) at the end of the agreement
The lease term is defined as the period during which the lessee has a noncancelable right to use an underlying asset, plus the following periods, if applicable:
- Periods covered by the lessee's option to extend the lease if it is reasonably certain that the lessee will in fact exercise that option.
- Periods covered by the lessee's option to terminate the lease if it is reasonably certain that the lessee will not exercise the option to terminate.
- Periods covered by the lessor's option to extend the lease if it is reasonably certain that the lessor will exercise that option.
- Periods covered by a lessor's option to terminate the lease if it is reasonably certain that the lessor will not exercise that option.
A short-term lease is defined as a lease that, at the commencement of the lease term, has a maximum possible term under the lease contract of 12 months (or less), including any options to extend, regardless of their probability of being exercised. For example, leases that are month-to-month are considered short-term. Short-term leases will be accounted for similarly to operating leases, with lease payments being recorded as expense or revenue by the lessee or lessor, respectively, based on the payment provisions of the lease contract.
Contracts that Transfer Ownership
A contract that (a) transfers ownership of the underlying asset to the lessee by the end of the contract and (b) does not contain termination options, but that may contain a fiscal funding or cancellation clause that is not reasonably certain of being exercised, should be reported as a financed purchase of the underlying asset by the lessee or sale of the asset by the lessor.
All Other Leases
Any agreement that does not qualify as either a short-term lease or ownership transfer contract will fall into this category, with the following accounting implications:
A lessee should recognize a lease liability and a lease asset at the commencement of the lease term unless the lease is a short-term lease or it transfers ownership of the underlying asset. The lease liability should be measured at the present value of payments expected to be made during the lease term (less any lease incentives). The lease asset should be measured at the amount of the initial measurement of the lease liability, plus any payments made to the lessor at or before the commencement of the lease term and certain direct costs.
A lessee should reduce the lease liability as payments are made and recognize an outflow of resources (for example, expense) for interest on the liability. The lessee should amortize the lease asset in a systematic and rational manner over the shorter of the lease term or the useful life of the underlying asset. The notes to financial statements should include a description of leasing arrangements, the amount of lease assets recognized, and a schedule of future lease payments to be made.
A lessor should recognize a lease receivable and a deferred inflow of resources at the commencement of the lease term, with certain exceptions for leases of assets held as investments, certain regulated leases, short-term leases, and leases that transfer ownership of the underlying asset. A lessor should not derecognize the asset underlying the lease. The lease receivable should be measured at the present value of lease payments expected to be received during the lease term. The deferred inflow of resources should be measured at the value of the lease receivable plus any payments received at or before the commencement of the lease term that relate to future periods.
A lessor should recognize interest revenue on the lease receivable and an inflow of resources (for example, revenue) from the deferred inflows of resources in a systematic and rational manner over the term of the lease. The notes to financial statements should include a description of leasing arrangements and the total amount of inflows of resources recognized from leases.
Other Lease Considerations
Unfortunately, not every lease transaction has components that are easy to dissect and complications to the lease accounting result. Certain complicated terms of leases could include contracts with multiple components and contract combinations, lease modifications and terminations, subleases and leaseback transactions, to name a few. Statement 87 provides guidance on these lease nuances and the respective accounting treatment.
WHAT DOES MY GOVERNMENTAL ENTITY NEED TO DO TO PREPARE FOR IMPLEMENTATION?
The first step that your governmental entity needs to do is to gather all contracts / agreements that may qualify as a lease. The determination as to whether or not leases need to be recorded and disclosed in your entity’s financial statements is not based on the total financial outflows / inflows of each individual lease but instead based on the aggregate of all financial outflows / inflows of leases in effect in your entity’s reporting period. Materiality is to be measured against the leases in aggregate, not against each individual lease.
The process of collecting, documenting, and calculating the required elements can be very arduous depending on how many leases your governmental entity has, and the complexity of such. At minimum, the following key terms of each lease should be abstracted to aid in your calculations and disclosures, if applicable:
- Lease name and or description
- Lease commencement date
- Description of any commitments or collateral required by the lease
- Related party lease
- Lease term (in years)
- Lease payment frequency
- Individual payment amount
- Annual interest rate (if not disclosed in lease agreement, your governmental entity’s incremental borrowing rate)
- Description of variable payments
- Whether the leased nonfinancial asset is depreciable or nondepreciable
- If nonfinancial asset is depreciable, estimated useful life (in years)
The preceding information represents a high-level overview of some of the significant concepts in Statement 87. In order to ensure proper implementation of Statement 87, your governmental entity should review and become familiar with Statement 87. In addition, as an additional reference source for aid in your implementation, refer to the GASB Implementation Guide No. 2019-3, Leases. The Implementation Guide provides guidance that clarifies, explains, and elaborates on the requirements of Statement 87 through a question and answer format. The aforementioned Implementation Guide also has been updated with additional questions and answers through GASB Implementation Guide No. 2020-1 and GASB Implementation Guide No. 2021-1.
Should you determine that you need assistance with the implementation of Statement 87, Bowman & Company LLP is here to help. The partners of our Governmental Services Department have a deep understanding of the GASB rules and can provide assistance in interpreting and applying them within your governmental entity. If such assistance is needed, please reach out to our partner in charge of your engagement for guidance.