Understanding the New Lease Accounting Standard for Government Entities under US GAAP
Overview of GASB 87
GASB 87 is a new lease accounting standard published by the Governmental Accounting Standards Board (GASB), which creates accounting standards for governmental entities that under US GAAP. The new standard was published on June 28, 2017. GASB 87 changes the way that companies account for leases in their financial disclosures, especially their balance sheets and income statements. The purpose of GASB 87 is to close a major accounting loophole: off-balance sheet operating leases.
Major Changes of GASB 87
Previously, governmental entities reported their leases similarly to how private entities reported leases under ASC 840. While finance leases would be capitalized on the balance sheet, operating leases would be reported in the footnotes. However, GASB 87 breaks away from FASB’s new lease rule, ASC 842. FASB chose to retain the dual classification of finance and operating leases and only require that operating leases be capitalized on the balance sheet. However, GASB chose to require that all operating leases now be accounted for as finance leases. As a result, leases previously classified as operating leases will not only be capitalized on the balance sheet, but also be reported differently on the income and cash flow statements.
GASB 87 Lease Definition
The definition of a lease has changed slightly. Under GASB 87, “A contract that conveys control of the right to use another entity’s non-financial asset (the underlying asset) as specified in the contract for a period of time in an exchange or exchange-like transaction.”
To qualify as a lease, the contract must meet 2 criteria:
The government entity must be able to obtain the service capacity of the asset as specified in the lease contract.
The government entity must be able to determine how the underlying asset is used as specified in the contract.
Leases that are considered short-term (having a term less than or equal to 12 months in length) and contracts that transfer ownership to the lessee are accounted for differently.
GASB versus FASB
GASB will eliminate the operating lease classification all together, requiring all leases to be reported as finance leases.
FASB will retain the dual classification of operating and finance leases, simply requiring that operating leases be capitalized on the balance sheet.
GASB will require lease liabilities to be reported as long-term debt, so may impact debt covenants and debt to equity ratios.
FASB will count operating lease liabilities as operating payables rather than as debt, so debt covenants and ratios should not be impacted.
GASB will require that interest expense on the lease liability and amortization expense on the lease asset be front-loaded on the income statement.
FASB will continue to straight-line the expense on operating leases, similar to how operating leases are expensed under ASC 840.
GASB will classify lease payments as capital financing outflows.
FASB will classify lease payments as operating outflows.
The differences between GASB and FASB reporting may impact certain industries, like health care and higher education, which are composed of entities that may be either public or private. Comparison between different entities within one industry that report under the two US GAAP standards may therefore become difficult.
GASB 87 Impacts to Financial Statements
Impact to the Balance Sheet
Under GASB 87 all leases will now be considered finance leases unless they meet certain exceptions and will be reported on the balance sheet. A new right-of-use (ROU) asset and lease liability will be presented separately on the balance sheet. Key financial metrics such as Return on Assets will be influenced through the addition of these new assets and liabilities to the balance sheet.
Impact to the Income Statement
Government entities must report an amortization expense for leased assets within the operating costs section of the income statement. An interest expense must be reported for lease liabilities within the finance costs section of the income statement. Previously, government entities reported a straight-line lease expense that was typically the same in each period of the lease. Now, the expenses for leases will be front-loaded as the amount of interest is reduced over the term of the contract.