THE NEW STANDARD
In many ways, the reporting requirements of the lessor are the mirror image of the requirements for lessees.
Lessors should initially recognize a lease receivable and a deferred inflow of resources. Lessors should measure the lease receivable at the present value of lease payments expected to be received, less amounts deemed uncollectible. Initial measurement of the lease receivable should include the following:
• Fixed payments
• Variable payments that depend on an index or rate
• Variable payments that are fixed in substance
• Residual value guarantee payments that are fixed in substance
• Any lease incentives payable to the lessee (this decreases the lease receivable)
Variable payments that are dependent on a lessee’s future performance or usage of the underlying asset should not be included in the lease receivable. These variable payments should be recognized as revenue in the period to which those payments relate. However, if any component of these variable payments is fixed, they should be included in the lease receivable.
Future lease payments to be received should be discounted using the interest rate the lessor charges the lessee or the implicit rate.
The deferred inflow of resources should be measured as the sum of the initial lease receivable plus lease payments received at or before the commencement of the lease term that apply to a future period, such as the final month’s rent, less any lease incentives paid to the lessee.
If the underlying asset in a lease is reported as an investment in accordance with GASB Statement No. 72, Fair Value Measurement and Application, the lessor should not apply the recognition and measurement provisions of GASB 87. The note disclosure requirement in GASB 87, paragraph 57d, should be applied. For example, if a lease is entered for the purpose of subleasing solely for profit, GASB Statement 72 would apply and not GASB 87. There are also different requirements for certain regulated leases, such as aviation leases.
Initial recognition will include a restatement of beginning balances in the year of implementation, so entities are required to calculate lease receivables and deferred inflows of resources as of July 1, 2020 in order to comply with GASB 87. Entities will need to examine their existing leases to determine whether they will continue to meet the definition of a leasing arrangement under GASB 87. For existing leases that will continue to meet the definition, all lease calculations should be made as if the commencement date of the lease is the earliest period presented. For most entities, this will be July 1, 2020.
A lessor should not derecognize the asset underlying the lease. The lessor should continue to depreciate the capital asset and continue to apply other applicable guidance.
In subsequent periods, the lessor will amortize the interest (i.e. discount) on the lease receivable and report that amount as a revenue. Payments received should be allocated first to interest receivable and then to the amortization of the lease receivable. The deferred inflow of resources should be systematically recognized as revenue over the lease term.
The lease receivable should be remeasured if certain changes have occurred at or before the financial reporting date and the changes are expected to significantly affect the amount of the lease receivable.
Generally, the deferred inflow of resources should be adjusted by the same amount as the lease receivable. GASB 87 requires notes to the financial statements for lease activities, other than short-term leases and certain regulated leases as follows:
a. General description of its leasing arrangements, including the basis, terms, and conditions on which any variable payments not included in the measurement of the lease receivable are determined
b. The total amount of revenue recognized in the reporting period from leases, if not already displayed separately on the face of the financial statements
c. The amount of revenue recognized in the reporting period for variable and other payments not previously included in the measurement of the lease receivable, including revenues related to residual value guarantees and termination penalties
d. The existence, terms, and conditions of options by the lessee to terminate the lease or abate payments if the lessor government has issued debt for which the principal and interest payments are secured by the lease payments
e. Additional disclosures are required for lessors that have regulated lease, sublease, sale-leaseback, and/or lease-leaseback transactions.
A government can be either a lessee or a lessor in a leasing arrangement. In this section, we discuss the general reporting requirements for lessees.
One major change that will affect both lessees and lessors with existing capital leases is that the lessee will NOT recognize and depreciate the underlying capital asset in the lease. For leases within the scope of GASB 87, a lessee should initially recognize a lease liability and an intangible right to use asset. The intangible right to use asset (lease asset) is a capital asset. The right to Office of the State Controller Financial Reporting Update - Page 3 use asset is distinct from the underlying asset itself (vehicle, building, etc.), which will continue to be reported on the lessor’s books.
Lessees should measure the lease liability at the present value of future minimum lease payments. Initial measurement of the lease liability should include the following:
• Fixed payments
• Variable payments that depend on an index or rate
• Variable payments that are fixed in substance
• Payments for residual value guarantees
• Exercise price of a purchase option if the lessee is reasonably certain to exercise the option
• Payments for early termination of the lease
• Lease incentives receivable from the lessor (this decreases the payment)
• Any other payments that are reasonably expected of being required based on an assessment of all relevant factors.
Variable payments that are dependent on a lessee’s future performance or usage of the underlying asset should not be included in the lease liability. These variable payments should be expensed when the obligation for payment is incurred. However, if any component of these variable payments is fixed, they should be included in the lease liability.
Future lease payments should be discounted using the interest rate the lessor charges the lessee or the implicit rate. If the interest rate is not readily determinable, the lessee’s estimated incremental borrowing rate should be used.
The lease asset should be measured as the sum of the initial lease liability plus prepayments made at or before the commencement of the lease term less lease incentives received plus initial direct costs that are ancillary charges necessary to place the lease asset in service. An example of an initial direct cost that would be capitalized is transportation charges for bringing the asset to its intended location where it will be placed into service. Other initial direct costs, such as, legal and administrative expenses, should be expensed.
Initial recognition will include a restatement of beginning balances in the year of implementation, so entities are required to calculate lease liabilities and assets as of July 1, 2020 in order to comply with GASB 87. Entities will need to examine their existing capital and operating leases to determine whether they will continue to meet the definition of a leasing arrangement under GASB 87. For existing leases that meet the definition, all lease calculations should be made as if the commencement date of the lease is the earliest period presented. For most entities, this will be July 1, 2020.
In subsequent periods, the lessee will amortize the interest (i.e. discount) on the lease liability and report that amount as interest expense. Payments should be allocated first to interest payable and then to the amortization of the lease liability. The lease asset should be amortized over the shorter of the lease term or the useful life of the underlying asset. If a lease contains a purchase option and it is reasonably certain that it will be exercised, the lease asset should be amortized over the useful life of the asset.
The lease liability should be remeasured if certain changes have occurred at or before the financial reporting date and the changes are expected to significantly affect the amount of the lease liability. Generally, the lease asset should be adjusted by the same amount as the lease liability.
GASB 87 requires notes to the financial statements for lease activities, other than short-term leases as follows:
a. General description of its leasing arrangements, including (1) the basis, terms, and conditions on which variable payments not included in the measurement of lease liability are determined and (2) the existence, terms, and conditions of residual value guarantees provided by the lessee not included in the measurement of the lease liability
b. The total amount of lease assets, and the related accumulated amortization, disclosed separately from other capital assets
c. The amount of lease assets by major classes of underlying assets, disclosed separately from other capital assets
d. The amount of expense/expenditure recognized in the reporting period for variable payments and other payments (such as residual value guarantees or termination penalties) not previously included in the measurement of the lease liability
e. Principal and interest requirements to maturity, presented separately, for the lease liability for each of the five subsequent fiscal years and in five-year increments thereafter
f. Commitments under leases before the commencement of the lease term
g. The components of any impairment loss associated with the underlying asset, including the amount of impairment loss and any related change in the lease liability
h. Additional disclosures are required for lessees that have sublease, sale-leaseback, and/or lease-leaseback transactions.
GASB 87 is effective for reporting periods beginning after June 15, 2021 (June 30, 2022 audits will be first). In June 2017, the Governmental Accounting Standards Board (GASB) issued GASB Statement No. 87, Leases. This statement supersedes or amends parts of 15 existing statements. GASB 87 overhauls the accounting and financial reporting of leases for state and local governments by establishing a single model for lease accounting based on the foundational principle that leases are financings of the right to use an underlying nonfinancial asset.
The objective of this statement is to improve the consistency of accounting and reporting for leases by requiring recognition of certain lease assets and liabilities for leases that previously were classified as operating leases. Under the new standard, leases previously classified as capital leases will be impacted also. GASB 87 will enhance the comparability, relevance, and reliability of information about the leasing activities of governments.
Under pre-GASB 87 guidance, governments distinguished between operating and capital leases. Beginning in fiscal year 2021 and for all prior periods presented, there is no longer a distinction between operating and capital leases. All leasing arrangements as defined by GASB 87 will now be treated as financings of the right to use the leased asset.
GASB 87 defines a lease as a contract that conveys control of the right to use another entity’s nonfinancial asset (the underlying asset, such as a vehicle, building, or equipment) as specified in the contract for a period of time in an exchange or exchange-like transaction. The contract must be legally enforceable. A contract conveys control of the right to use the underlying asset if it has both of the following:
a. The right to obtain the present service capacity from use of the underlying asset as specified in the contract and
b. The right to determine the nature and manner of use of the underlying asset specified in the contract.
Contracts for services are excluded, and contracts that contain both a lease component and a service component should separate and report only the lease component.
For arrangements that meet the GASB 87 definition of a lease, entities will be required to determine the lease term applicable to that lease, whether the entity is a lessee or a lessor in the arrangement. The lease term is the noncancelable period, plus periods covered by the lessee’s and lessor’s options to:
• Extend the lease, if reasonably certain of being exercised.
• Terminate the lease, if reasonably certain of NOT being exercised.
Periods for which both the lessee and lessor have an option to terminate or both parties have to agree to extend the lease are cancelable periods and are excluded from the lease term. Fiscal funding/cancelation clauses are ignored unless reasonably certain of being exercised.
A lessee or a lessor is ‘reasonably certain’ if they have evaluated relevant factors such as economic incentives or disincentives (cost to terminate, market rates for new leases, cancellation penalties, etc.), the history of exercising options to extend or terminate, and how essential the leased asset is to a government’s operations. After evaluating these factors, an entity can be reasonably certain if there is a greater than probable chance that one of the above options will or will not be exercised. In certain cases, lease terms should be reassessed. For example, if a lessee exercises an option that it was previously uncertain about, the lease term should be adjusted.
GASB 87 specifically exempts short-term leases from the provisions of the standard. A short term lease is one that has a maximum possible term under the contract, including options to extend, of 12 months or less as determined at the beginning of the lease. Options to terminate the lease are excluded. A short-term lease should be accounted for as expenses for the lessee upon payment and revenues for the lessor upon receipt of the payment, similarly to how operating leases were recognized under previous guidance.
IDENTIFYING LEASES AND DETERMINING THE LEASE TERM
The implementation of this statement will require a significant expenditure of time, effort, and resources for all entities leading up to the fiscal year 2021 implementation date and thereafter. It is important to begin the process of identifying, examining, and maintaining their lease contracts now to comply with reporting requirements for GASB 87. The change in reporting requirements for leases will require entities to examine current reporting for existing and potential leases to determine whether they meet the new requirements of GASB 87.
Step 1: Read GASB 87 and GASB Implementation Guide 2019-3, Leases
Begin by reading GASB 87, Leases. Also refer to the Implementation Guide 2019-3, Leases, which provides examples and clarification on the requirements contained within GASB 87.
Step 2: Identify Leases at Your Organization
Examine your Procurement Process and Form a Leases Workgroup. Examine your agency’s process for entering into contracts. If several departments are involved in this process, form a leases workgroup to ensure that all types of current and potential leasing contracts can be identified.
Examine Existing and Known Leases. Begin the process of identifying leases by gathering contracts that are already reported as operating or capital leases.
Evaluate Other Contracts for Embedded Leases. Not every lease is labeled a “lease agreement,” and identifying embedded leases can involve considerable time and judgment as many of these contracts may not have been identified as leases in the past. Embedded leases are components within contracts that allow for the use of an asset, with the user having control over the right to use that asset. Such contracts (or components of such contracts) may be defined as leases under GASB 87 even if the contract does not use the word ‘lease’.
Step 3: Analyze and Document Key Lease Terms, Evaluate Bond and Other Debt Covenants, Make Necessary Changes to Internal Controls and Processes
Analyze your lease agreements further, focusing on your largest dollar value leases first. Look for key elements for the calculation of liabilities, assets, and deferred inflows of resources per GASB 87. Maintaining this information on a per lease basis will be essential to the accurate and complete reporting of leases for your entity.
Those entities that are statutorily permitted to issue debt in their own name should examine their bond and other debt covenants to determine how a lease liability will affect the requirements contained therein.
GASB 87 introduces additional considerations around an entity’s internal control structure. In order to ensure accurate and complete reporting of leases, there will be an increased focus on internal controls related to identification of leasing transactions, ongoing maintenance of leasing information, and robust management review of leasing information for financial reporting at an agency level.
GUIDE TO IDENTIFYING
LEASES UNDER GASB 87
New guidance is needed because the existing leasing standards have been in effect for decades without being changed or reconsidered. They do not take the definitions of assets and liabilities as defined by the GASB into consideration. Previous standards have been criticized for creating an artificial distinction between capital and operating leases, when the economic impact is the same for the lessee.
Entities enter into leasing arrangements within the normal course of business. With the new standard, a lease is defined as a contract that conveys control of the right to use another entity's nonfinancial asset (the underlying asset) as specified in the contract for a period of time in an exchange or exchange-like transaction. Examples of nonfinancial assets include buildings, land, vehicles, and equipment.
GASB 87 does NOT apply to:
a.) Leases of intangible assets, biological assets, and inventory (e.g. software subscriptions, animals/plants, and finished goods inventory)
b.) Service concession arrangements
c.) Leases in which the underlying asset is financed with conduit debt
d.) Supply contracts; such contracts convey access to output of assets, not control of right to use asset e.) Leases of financial assets reported as investments
f.) Short term leases, as defined in GASB 87 paragraph 16 (see definition below)
g.) Contracts that transfer ownership of the underlying asset at the end of the lease term (such contracts are considered financed purchases)
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. Options to terminate the lease are excluded. For a lease that is cancellable by either the lessee or the lessor, such as a rolling month-to-month lease or a year-to-year lease, the maximum possible term is the noncancelable period, including any notice periods. For example, if an agency has a year-to-year lease on a machine but must give at least 90-days notice to cancel the lease, the lease term is the 12-month non-cancellable period, PLUS the notice period of 90 days. As such, the total lease term is 15 months and would not be considered a short-term lease. However, in this example, if there is no required notice period, the lease term would be 12 months, and as such a short-term lease is not subject to the requirements of GASB 87.
The period during which a lessee has a non-cancellable right to use an underlying asset.
An asset is leased by one party (first party) to another party and then leased back to the first party.
A lease by a lessee of part or all leased assets to another person but with the original lessee retaining rights or interest under the original lease.
Involves the sale of an underlying asset by the owner, and a lease of the property back to the seller.
A government agency may place a fiscal funding clause in a lease, which states that the government agency has the option to break the lease if it does not receive the money to make the lease payment through the appropriation process. The fiscal funding clause provides the government agency with a safety measure that eliminates the risk that it will have to pay high cancellation fees.
The rate that, at the inception of the lease, the lessee would have incurred to borrow over a similar term, the resources necessary to purchase the leased asset.
The discounted value of a future amount or amounts of cash, assuming a given rate of interest.
Elements of a contract that are not related to the use of a leased asset. Commonly found in real estate leases.