GASB 87 - Leases: A Comprehensive Guide

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Table of Contents

1. Introduction
2. Overview of GASB 87
3. Key Changes from Previous Standards
4. Definition of a Lease
5. Lessee and Lessor Accounting
6. Lease Term and Payment Considerations
7. Implementation Challenges
8. Impact on Financial Statements
9. Case Studies
10. Future Implications
11. Conclusion

Introduction

Governmental Accounting Standards Board (GASB) Statement No. 87, also known as GASB 87, represents a significant shift in lease accounting for governmental entities. Introduced in June 2017 and effective for fiscal years beginning after June 15, 2021, GASB 87 aims to enhance the relevance and consistency of financial reporting for leases by governmental entities. This comprehensive guide will explore the various aspects of GASB 87, its impact on financial reporting, and the challenges and opportunities it presents for accounting professionals and governmental organizations.

The implementation of GASB 87 marks a pivotal moment in governmental accounting, as it fundamentally changes how leases are recognized, measured, and reported in financial statements. By aligning lease accounting more closely with the economic reality of lease transactions, GASB 87 seeks to provide a more accurate representation of a government's financial position and its long-term obligations. This change is particularly significant given the prevalence of leasing arrangements in governmental operations, from office spaces and equipment to land and vehicles.

As we delve into the intricacies of GASB 87, it's important to recognize its far-reaching implications for financial statement preparers, auditors, and users of governmental financial reports. This blog post will serve as a comprehensive resource, offering insights into the key aspects of GASB 87, practical implementation guidance, and an analysis of its potential long-term effects on governmental financial reporting.

Overview of GASB 87

GASB 87 is a lease accounting standard that establishes a single model for lease accounting based on the principle that leases are financings of the right to use an underlying asset. This standard applies to all state and local governmental entities in the United States and aims to enhance the usefulness of governments' financial statements by requiring the recognition of certain lease assets and liabilities that were previously not reported.

The primary objectives of GASB 87 include:

• Improving the consistency of financial reporting across governmental entities
• Enhancing the comparability of financial statements between governmental and non-governmental entities
• Providing a more accurate representation of a government's financial position by recognizing lease obligations on the balance sheet
• Increasing transparency regarding the government's leasing activities and their financial impact

Under GASB 87, leases are defined as contracts that convey the right to use another entity's nonfinancial asset (the underlying asset) for a period of time in an exchange or exchange-like transaction. This definition encompasses a wide range of leasing arrangements, including those for buildings, land, vehicles, and equipment.

The standard requires lessees to recognize a lease liability and an intangible right-to-use lease asset for all leases with terms exceeding 12 months. Lessors, on the other hand, are required to recognize a lease receivable and a deferred inflow of resources. This approach aims to provide a more comprehensive picture of a government's leasing activities and their financial implications.

Key Changes from Previous Standards

GASB 87 introduces several significant changes compared to previous lease accounting standards. These changes fundamentally alter how governmental entities account for and report leases in their financial statements. The following table summarizes the key differences between GASB 87 and previous standards:

Aspect	Previous Standards	GASB 87
Lease Classification	Operating and Capital Leases	Single Model (Finance Lease)
Balance Sheet Recognition	Capital Leases Only	All Leases (except short-term)
Lessee Accounting	Expense Recognition Varies	Consistent Expense Recognition
Lessor Accounting	Varies Based on Classification	Lease Receivable and Deferred Inflow
Disclosure Requirements	Limited	Expanded

The most significant change introduced by GASB 87 is the shift from the dual model of operating and capital leases to a single model for lease accounting. Under previous standards, operating leases were not reported on the balance sheet, which could potentially understate a government's liabilities and assets. GASB 87 addresses this by requiring the recognition of lease assets and liabilities for all leases with terms exceeding 12 months, regardless of their previous classification.

This change has several important implications:

1. Increased transparency: By recognizing all leases on the balance sheet, GASB 87 provides a more accurate representation of a government's financial position and obligations.
2. Consistency in reporting: The single model approach ensures that all leases are treated similarly, improving comparability between different governmental entities and their financial statements.
3. Enhanced decision-making: Users of financial statements, including policymakers and the public, will have access to more comprehensive information about a government's leasing activities and their financial impact.
4. Alignment with other standards: GASB 87 brings governmental lease accounting more in line with other accounting standards, such as those used in the private sector (e.g., FASB ASC 842).

Another significant change is the treatment of lease-related expenses for lessees. Under previous standards, operating lease payments were typically recognized as expenses on a straight-line basis over the lease term. With GASB 87, lessees will recognize amortization expense for the lease asset and interest expense on the lease liability, which may result in a different expense recognition pattern over the lease term.

For lessors, GASB 87 introduces the concept of a lease receivable and a deferred inflow of resources, replacing the previous approach of treating leases as either sales-type, direct financing, or operating leases. This change aims to provide a more accurate representation of the lessor's financial position and the economic substance of lease transactions.

Lastly, GASB 87 expands the disclosure requirements for both lessees and lessors. These enhanced disclosures provide users of financial statements with more detailed information about the nature and financial impact of a government's leasing activities, including details about variable lease payments, residual value guarantees, and lease termination penalties.

Definition of a Lease

GASB 87 provides a specific definition of a lease that is crucial for determining which contracts fall within the scope of the standard. According to GASB 87, 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."

This definition contains several key elements that must be understood to properly identify and account for leases under GASB 87:

1. Contract: The arrangement must be legally enforceable, whether written or verbal.
2. Control: The lessee must have the right to control the use of the underlying asset.
3. Nonfinancial asset: The underlying asset must be tangible, such as buildings, land, vehicles, or equipment.
4. Specified in the contract: The asset must be explicitly or implicitly identified in the contract.
5. Period of time: The contract must cover a defined term, which can be fixed or variable.
6. Exchange or exchange-like transaction: There must be a reciprocal transfer of value between the parties.

It's important to note that GASB 87 applies to both leases of real estate (such as land and buildings) and leases of equipment and other capital assets. However, there are certain exceptions and scope exclusions to be aware of:

• Short-term leases (12 months or less, including options to extend)
• Leases of intangible assets (e.g., patents, software licenses)
• Leases of biological assets (e.g., timber, living plants and animals)
• Leases of inventory
• Service concession arrangements
• Supply contracts (e.g., power purchase agreements)

When determining whether a contract meets the definition of a lease under GASB 87, entities should carefully evaluate each element of the definition. This assessment may require judgment, particularly in cases where the contract includes both lease and non-lease components or where the control element is not immediately clear.

For example, a contract that provides both the right to use equipment and maintenance services would need to be evaluated to determine if the lease and non-lease components should be accounted for separately. Similarly, arrangements such as cloud computing contracts or certain types of service agreements may require careful analysis to determine if they meet the definition of a lease under GASB 87.

By providing a clear and comprehensive definition of a lease, GASB 87 aims to ensure consistent application of the standard across various types of leasing arrangements and governmental entities. This definition serves as the foundation for the subsequent recognition, measurement, and reporting requirements outlined in the standard.

Lessee and Lessor Accounting

GASB 87 introduces significant changes to both lessee and lessor accounting. This section will provide detailed guidance on how lessees and lessors should account for leases under the new standard, including recognition, measurement, and reporting requirements.

Lessee Accounting

Under GASB 87, lessees are required to recognize a lease liability and an intangible right-to-use lease asset for all leases with terms exceeding 12 months. This approach applies to both leases that were previously classified as operating leases and those classified as capital leases.

Initial Recognition and Measurement:

• Lease Liability: Initially measured at the present value of future lease payments over the lease term, discounted using the rate implicit in the lease or the lessee's incremental borrowing rate.
• Lease Asset: Initially measured as the sum of the initial lease liability, plus any lease payments made to the lessor at or before the commencement of the lease term, less any lease incentives received from the lessor at or before the commencement of the lease term, plus any initial direct costs necessary to place the lease asset into service.

Subsequent Measurement:

• Lease Liability: Reduced by lease payments made and increased by interest incurred.
• Lease Asset: Amortized over the shorter of the lease term or the useful life of the underlying asset.

Expense Recognition:

Lessees will recognize two types of expenses:

1. Amortization expense on the lease asset (typically straight-line)
2. Interest expense on the lease liability (using the effective interest method)

Lessor Accounting

GASB 87 also introduces changes to lessor accounting, requiring lessors to recognize a lease receivable and a deferred inflow of resources for all leases, except for short-term leases.

Initial Recognition and Measurement:

• Lease Receivable: Initially measured at the present value of future lease payments, discounted using the rate implicit in the lease.
• Deferred Inflow of Resources: Initially measured as the sum of the initial lease receivable, plus any lease payments received from the lessee at or before the commencement of the lease term that relate to future periods, less any lease incentives paid to, or on behalf of, the lessee at or before the commencement of the lease term.

Subsequent Measurement:

• Lease Receivable: Reduced by lease payments received and increased by interest revenue recognized.
• Deferred Inflow of Resources: Generally amortized on a straight-line basis over the lease term.

Revenue Recognition:

Lessors will recognize two types of inflows:

1. Lease revenue (from amortization of the deferred inflow of resources)
2. Interest revenue (on the lease receivable)

It's important to note that under GASB 87, lessors do not derecognize the underlying asset. Instead, they continue to apply other applicable guidance to account for the underlying asset, such as depreciation.

Lease Term and Payment Considerations

Determining the lease term and properly accounting for various types of lease payments are crucial aspects of implementing GASB 87. This section will discuss how to determine the lease term and the impact of variable payments, renewal options, and termination options on lease accounting.

Determining the Lease Term

The lease term is defined as the period during which a lessee has a noncancelable right to use an underlying asset, plus the following periods, if applicable:

1. Periods covered by a lessee's option to extend the lease if it is reasonably certain that the lessee will exercise that option
2. Periods covered by a lessee's option to terminate the lease if it is reasonably certain that the lessee will not exercise that option
3. Periods covered by a lessor's option to extend the lease if it is reasonably certain that the lessor will exercise that option
4. Periods covered by a lessor's option to terminate the lease if it is reasonably certain that the lessor will not exercise that option

The assessment of whether it is "reasonably certain" that an option will be exercised should consider all relevant factors that create an economic incentive for the lessee or lessor. These factors may include:

• Contractual terms and conditions for the optional periods compared with current market rates
• Significant leasehold improvements undertaken or expected to be undertaken
• Costs relating to the termination of the lease and the signing of a new lease
• The importance of the underlying asset to the lessee's operations
• Historical exercise patterns for similar leases

Lease Payments

GASB 87 provides guidance on various types of lease payments and how they should be accounted for:

1. Fixed Payments: These are included in the measurement of the lease liability and lease receivable.
2. Variable Payments Based on an Index or Rate: Initially measured using the index or rate at the commencement of the lease term. Subsequent changes in the index or rate are recognized as they occur.
3. Other Variable Payments: Payments that depend on the lessee's performance or usage of the underlying asset are not included in the lease liability or receivable. These are recognized as expenses or revenues in the period incurred.
4. Residual Value Guarantees: Amounts probable of being owed by the lessee under residual value guarantees should be included in the measurement of the lease liability.
5. Purchase Options: If it is reasonably certain that a purchase option will be exercised, the exercise price should be included in the lease payments.
6. Termination Penalties: If it is reasonably certain that a termination option will be exercised, the termination penalty should be included in the lease payments.

Reassessment of the Lease Term and Lease Payments

GASB 87 requires lessees and lessors to reassess the lease term and lease payments in certain circumstances:

• When there is a significant event or change in circumstances that is within the control of the lessee or lessor and directly affects the determination of the reasonably certain assessment
• When the lessee elects to exercise an option even though it was previously determined that it was not reasonably certain to do so
• When an event written into the contract that requires an extension or termination of the lease takes place

These reassessments may result in a remeasurement of the lease liability and lease asset (for lessees) or the lease receivable and deferred inflow of resources (for lessors).

Implementation Challenges

The implementation of GASB 87 presents several challenges for governmental entities. This section will identify common challenges and provide strategies to address them.

Common Implementation Challenges

1. Identifying All Leases: Many organizations may struggle to identify all contracts that meet the definition of a lease under GASB 87, especially if lease arrangements are decentralized across departments.
2. Data Collection and Management: Gathering all necessary lease data, including payment schedules, renewal options, and variable payment terms, can be time-consuming and complex.
3. Determining Appropriate Discount Rates: Entities may face difficulties in determining the appropriate discount rate, especially when the rate implicit in the lease is not readily determinable.
4. Technology and Systems: Existing accounting systems may not be equipped to handle the new lease accounting requirements, necessitating upgrades or new software implementations.
5. Stakeholder Education: Educating internal stakeholders, including management and governing boards, about the changes and their impact on financial statements can be challenging.
6. Resource Constraints: Many governmental entities may lack the necessary resources, both in terms of personnel and expertise, to implement GASB 87 effectively.
7. Lease vs. Non-Lease Component Separation: Contracts that contain both lease and non-lease components require careful analysis and potential separation for accounting purposes.
8. Reassessment and Remeasurement: Ongoing requirements to reassess lease terms and remeasure lease liabilities and assets can be complex and time-consuming.

Strategies to Address Implementation Challenges

1. Early Planning and Assessment: Begin the implementation process early by conducting a comprehensive inventory of all contracts that could potentially contain leases.
2. Cross-Functional Teams: Form cross-functional teams involving accounting, legal, procurement, and IT departments to ensure all aspects of lease accounting are addressed.
3. Centralized Lease Management: Implement a centralized lease management system to improve data collection, management, and reporting.
4. Technology Solutions: Consider investing in lease accounting software that can automate calculations, generate journal entries, and produce required disclosures.
5. Staff Training: Provide comprehensive training to accounting staff on the new lease accounting requirements and any new systems or processes implemented.
6. Engage with Auditors: Communicate early and often with external auditors to ensure alignment on key judgments and interpretations of GASB 87.
7. Develop Policies and Procedures: Establish clear policies and procedures for lease identification, data collection, and ongoing management of lease accounting.
8. Leverage External Resources: Consider engaging external consultants or temporary staff to assist with implementation if internal resources are constrained.
9. Phased Implementation: For entities with a large number of leases, consider a phased implementation approach, starting with the most significant leases.
10. Ongoing Monitoring: Establish processes for ongoing monitoring of lease portfolios to ensure compliance with reassessment and remeasurement requirements.

By proactively addressing these challenges and implementing robust strategies, governmental entities can navigate the complexities of GASB 87 implementation more effectively and ensure compliance with the new standard.

Impact on Financial Statements

The implementation of GASB 87 has a significant impact on governmental entities' financial statements. This section will analyze how GASB 87 affects various components of financial statements, including the balance sheet and statement of revenues, expenses, and changes in fund net position.

Balance Sheet Impact

For Lessees:

• Assets: Recognition of right-of-use assets for all leases with terms exceeding 12 months. This will increase total assets on the balance sheet.
• Liabilities: Recognition of lease liabilities for the present value of future lease payments. This will increase total liabilities on the balance sheet.

For Lessors:

• Assets: Recognition of lease receivables for the present value of future lease payments. The underlying asset remains on the balance sheet.
• Deferred Inflows of Resources: Recognition of deferred inflows of resources related to leases.

These changes will likely result in a significant increase in reported assets and liabilities for many governmental entities, particularly those with substantial leasing activities.

Statement of Revenues, Expenses, and Changes in Fund Net Position Impact

For Lessees:

• Expenses: Instead of a single lease expense (for operating leases), entities will now recognize:
  1. Amortization expense for the right-of-use asset
  2. Interest expense on the lease liability
• This change may result in higher total expenses in the early years of a lease and lower expenses in later years, compared to the straight-line expense recognition pattern under previous standards.

For Lessors:

• Revenues: Entities will recognize:
  1. Lease revenue (from the amortization of the deferred inflow of resources)
  2. Interest revenue (on the lease receivable)
• This may result in a different pattern of revenue recognition compared to previous standards, particularly for leases previously classified as operating leases.

Cash Flow Statement Impact

While GASB 87 does not directly change the amount of cash flows, it does affect how lease-related cash flows are classified in the statement of cash flows:

• Principal payments on lease liabilities will be classified as financing activities
• Interest payments on lease liabilities will typically be classified as operating activities
• Variable lease payments and short-term lease payments not included in the lease liability will be classified as operating activities

Note Disclosures

GASB 87 requires enhanced disclosures about leasing activities, including:

• General description of leasing arrangements
• Total amount of lease assets and accumulated amortization, by major class of underlying assets
• Principal and interest requirements to maturity for lease liabilities
• Lease commitments for short-term leases
• Components of lease revenue and expense
• Information about significant assumptions and judgments made in applying the standard

These expanded disclosures will provide users of financial statements with more comprehensive information about an entity's leasing activities and their financial impact.

Financial Ratios and Metrics

The changes introduced by GASB 87 may significantly impact various financial ratios and metrics used to assess an entity's financial health:

• Debt-to-Equity Ratio: May increase due to the recognition of lease liabilities
• Return on Assets: May decrease due to the increase in total assets
• EBITDA: May increase as lease expenses are replaced by amortization and interest expenses
• Working Capital: May be affected by the current portion of lease liabilities

It's important for entities to communicate these changes to stakeholders and potentially revise debt covenants or performance metrics that may be affected by the new lease accounting model.

Case Studies

To illustrate the practical application of GASB 87, let's examine two case studies of governmental entities that have adopted the new standard.

Case Study 1: City of Springfield

The City of Springfield, a medium-sized municipality, implemented GASB 87 for its fiscal year ending June 30, 2022. The city had several significant leases, including office buildings, vehicles, and equipment.

Implementation Process:

1. Formed a cross-functional team including finance, legal, and IT departments
2. Conducted a comprehensive review of all contracts to identify leases
3. Implemented a lease management software to track and account for leases
4. Provided training to staff on the new standard and software

Key Challenges:

• Identifying embedded leases in service contracts
• Determining appropriate discount rates for each lease
• Educating department heads on the importance of centralized lease management

Financial Statement Impact:

• Recognized $50 million in right-of-use assets and lease liabilities
• Increased total assets and liabilities by 8%
• Changed expense recognition pattern for major building leases, resulting in higher expenses in the first year of implementation

Lessons Learned:

• Early planning and stakeholder communication were crucial for successful implementation
• Investing in lease management software significantly eased the ongoing compliance burden
• Developing clear policies for lease identification and management helped ensure consistency across departments

Case Study 2: State University System

To further illustrate the implementation of GASB 87, let's examine how a state university system adapted to the new lease accounting standard.

Background

The state university system comprises five campuses across the state, each with various leasing arrangements for equipment, buildings, and land. Prior to GASB 87, these leases were classified as either operating or capital leases, with only capital leases reported on the balance sheet.

Challenge

The university system needed to review and reclassify all existing leases, including those previously considered operating leases, to comply with GASB 87. This involved analyzing hundreds of contracts and determining which ones met the new definition of a lease under the standard.

Implementation Process

1. Conducted a comprehensive inventory of all leases across all campuses
2. Developed a centralized lease management system to track and monitor all leases
3. Trained accounting staff on the new standard and its implications
4. Worked with external auditors to ensure proper classification and measurement of leases
5. Updated financial reporting processes to incorporate the new lease accounting requirements

Results

After implementing GASB 87, the university system saw significant changes in its financial statements:

• Recognition of $150 million in right-of-use assets and corresponding lease liabilities on the balance sheet
• Improved transparency in financial reporting, providing stakeholders with a more accurate picture of the system's lease obligations
• Enhanced ability to make informed decisions about future leasing arrangements

Lessons Learned

The implementation process highlighted the importance of:

• Starting early and allowing ample time for lease review and classification
• Investing in robust lease management software to streamline the process
• Collaborating closely with all departments to ensure comprehensive lease identification
• Providing ongoing training and support for staff to adapt to the new accounting requirements