Significant Change in Accounting and Disclosures for Lease Arrangements
GASB 87 (“Leases”) marks a significant change in the accounting and disclosures for lease arrangements, especially for operating leases under historic NCGA Statement 5 and GASB 13 guidance. As part of determining the financial reporting impacts from the new guidance, implementing and executing the rules on an ongoing basis requires many decisions and judgment by management. The following are some of the more common decision points on contracts management where the entity is the lessee.
GASB 87 is effective for all government entities with reporting periods beginning after June 15, 2020, as amended by GASB 95. Early adoption is encouraged. Adoption should be retroactive, restating financial statements for all prior periods presented, based on the facts and circumstances that existed at the beginning of the period of implementation.
Lease guidance scoping, embedded leases and materiality
GASB 87 applies to all leases, including subleases, with the exception of several areas that will continue to follow other accounting guidance: donated assets (“GASB 33”), intangible assets (“GASB 51”), biological assets, inventory, supply contracts, intra-entity leases, service concession arrangements (“GASB 60”), and investment assets, such as rental property (“GASB 72”). However, even agreements that are scoped out may have components that contain the right to use and control an identified asset and may be scoped into GASB 87. The same is true for other types of arrangements that contain a significant service element in addition to the right to use an asset. Entities will need to assess the possibility of embedded leases across its contract base, being mindful of these potential additional areas. Judgment is required when determining whether to separate the leased asset from the service agreement. Factors to consider include how important is the asset to the contract obligations (more important means more likely to contain a lease), and whether the entity controls a specified asset (which is indicative of a lease).
The guidance recognizes the cost/benefit consideration for including every lease arrangement for analysis but does not specify a threshold for scoping out immaterial arrangements. Entities can look to their existing capitalization thresholds for capital assets as a starting point, but being mindful that excluding a significant number of relatively small leases could misstate the entity’s statement of net position by a significant amount. Entities might also consider any conventions in place regarding liability recognition thresholds, as GASB 87 creates both a right of use asset and a lease liability. Entities should be able to demonstrate that the amounts excluded would not materially misstate its results when determining the threshold. Further the amount of the resulting asset or liability is not known until calculating the amount under the guidance, so entities may need to define their thresholds in terms of required annual lease payments rather than an asset or liability threshold.
Separating non-lease components from lease payments
GASB 87 requires entities to analyze each lease and only record a right of use asset and liability for the lease components of lease agreements. There are many common non-lease components included in agreements, which generally provide for other services. Examples include maintenance for equipment and operating costs for real estate (i.e., common area maintenance, insurance, property tax). For many entities, analyzing each lease to separate payments at this level of detail may be quite onerous especially when accounting systems and reporting schedules have historically only tracked the total payment amount.
Certain asset classes may have allocations that are easier to determine because they are stated in the agreements at standalone values (equipment and related servicing) while others may not be as obvious to break out (real estate). Estimating amounts may take time and depending on the nature of the asset and materiality of the amounts involved, accounting personnel may need assistance from others within the entity, from the lease vendors, or outside valuation experts to develop these estimates.
If it is not practical to estimate the payment amount to allocate to each component, GASB 87, paragraphs 67 and 68, allows the combining of all non-lease components with lease component payments, which can simplify the analysis, but will create a larger right of use asset and lease liability on the entity’s statement of net position.
Judgment establishing lease term and purchase options
The lease term is the sum of the non-cancelable periods, plus areas that require judgment: renewal options when they are ‘reasonably certain’ of exercising or early termination options when they are ‘reasonably certain’ of occurring. ‘Reasonably certain’ is not specifically quantified in the guidance but represents a high hurdle – it is meant to be greater than ‘probable’ and equates to the threshold of ‘reasonably assured’ under GASB 62 and should be indicative of an economic compulsion or incentive to renew the lease. GASB 87 paragraph 14 details several factors to consider when making this assessment which include the significant economic incentives such as cost of the option periods compared to current and expected market rates, significant economic disincentives such as costs to terminate the lease and enter into a new lease, the entity’s history of exercising options, and the importance of the leased asset to the provision of government services. There may be opportunities to have similar documented assumptions for similar leases, but entities should be careful to assess where strategic plans may differ across assets or locations. Other factors to consider include the existence of a bargain purchase option, a purchase option with a substantial penalty if not exercised, and leasehold improvements that have substantial value at the end of the base term if abandoned.
The length of the base term and renewal periods can also increase the complexity of the judgments required. For example, a 20-year base term with 10-year renewal options may be challenging to assess due to the long forecast periods involved. On the opposite end of the spectrum are ‘evergreen’ or ‘month-to-month’ leases that have short initial terms but have an expectation of many renewals. In these cases, the quantitative assessments may prove challenging, and instead documenting discussions with entity personnel responsible for the assets may lead be the primary support for the renewal assumptions based on the underlying expected use period.
Leases with an option to purchase the asset would undergo analysis similar to the lease term determination discussed above.
GASB 87 does not require the right of use accounting for leases with a maximum possible lease term of 12 months or less (including any renewal periods regardless of their probability of being exercised). Such leases are to be accounted for similar to operating leases under the old guidance where payments are recognized as outflows of resources based on the payment provisions of the lease contract.
Periodic reassessment of the lease term
Although there are a variety of assumptions that are considered in determining the initial right of use asset and lease liability, subsequent re-measurement of the asset and liability should be limited to only certain circumstances. Lessees should reassess the lease term only if:
- The lessee chooses to exercise an option that previously was not contemplated,
- The lessee chooses not to exercise an option that previously was assumed to be exercised, or
- An event occurs that is specified in the lease contract that requires extension or termination of the lease.
If a lease is reassessed and re-measured, the entity should also update the assumptions surrounding variable lease payments, such as updating the index or rate to the current amounts, as these amounts are typically only established at the beginning of the lease.
Judgment in the calculation of lease payments
Most of the lease payment components are relatively straightforward to determine, though the exercise becomes voluminous with a large population of leases. Some aspects require judgment however. Lease payments should include purchase or early termination option payments when those assumptions are reasonably certain of occurring. This determination should be consistent with the ‘lease term’ section above for these areas. Similarly, amounts that are probable of being paid as part of a residual value guarantee due to damage or wear and tear to the asset should be estimated and included in the lease payments.
Many leases of equipment or facilities include obligations of the lessee to remove equipment and leasehold improvements, or to overhaul or restore the asset to its original condition before returning it. Obligations of the lessee to return an asset to its underlying condition, such as removing leasehold improvements, would not be included in the calculation of lease payments but instead would be accounted for as an asset retirement obligation under GASB 83. Obligations of the lessee to restore functionality or otherwise improve the asset at the end of the lease to benefit the lessor going forward and not the lessee would be included in the calculation of lease payments. Judgment is required in these areas for the estimated amount of the end lease costs as well as determining the classification of such amounts as the lease wording or cost estimates may not clearly differentiate between the two concepts.
Judgment in determining the discount rate to apply to lease payments
For lessees, the discount rate applied against lease payments is the rate implicit in the lease if known, or otherwise, the lessee’s incremental borrowing rate. GASB 87 paragraph 23 defines the incremental borrowing rate as the rate a lessee would pay to borrow the lease payment amounts during the lease term. Assumptions within the incremental borrowing rate are more sensitive to estimate when the lease payments are large as well as when there are longer lease terms. Entities may have lender quotes or estimates for such rates to assist in this process. Oftentimes, entities will need to calculate and document their assumptions on their own. One approach is to start with the entity’s borrowing rate for unsecured debt for a comparable amount and time period, and then decrease the rate based on full collateral. Entities may be able to access market quotes for entities with similar debt ratings or financial positions as well to assist in this process.
The rates used at initial adoption of the guidance are typically more sensitive than ongoing rates since the entire lease population is discounted for the first time upon adoption, while going forward only new leases or those requiring reassessment will require new discount rates. Although there are no disclosure requirements regarding the assumptions used in determining the discount rate, entities are required to disclose principal and interest requirements to maturity, presented separately. So entities should have these key assumptions well documented to support their internal control and review efforts, which will also benefit their footnote disclosure efforts.
After the initial adoption of GASB 87, new leases are analyzed using the discount rate at lease inception date. As this changes over time, entities should have a documented and repeatable process to determine rates as needed going forward.
Impairment tests for right of use lease assets
The right of use lease assets created by adopting GASB 87 are subject to the impairment requirements of GASB 42. As defined in GASB 42, paragraph 9, an asset is impaired if:
- There is evidence of physical damage to the level that restoration efforts are needed to restore service utility,
- Enactment or approval of laws or regulations which the underlying asset does not meet,
- Technological development or evidence of obsolescence,
- Change in the manner or expected duration of use of the asset, or
- Construction stoppage.
GASB 42 contemplates the varying levels of detail by which capital assets are recorded. Therefore, for assessing impairment, the leases asset should be considered with the group of assets to which it belongs as appropriate.
Unlike the FASB lease guidance (“ASC 842”), GASB 87 does not require the disclosure of all significant assumptions, such as the determination of the discount rate. GASB 87, however, does require certain disclosures related to leases with variable payments. Disclosures of leases with variable payments must include the basis, terms, and conditions on which variable payments, and residual value guarantees, not included in the measurement of the lease liability are determined. These disclosures must also include the amount lease expense recognized in the reporting period for variable payments not previously included in the measurement of the liability. Other disclosures include those separating out lease assets from other capital assets, by major asset class; principal and interest requirements, consistent with other long term debt; commitments under leases before the commencement of the lease term; and the components of any impairment losses on right of use lease assets.
If you have any questions or concerns on how this may affect you, please contact your Cherry Bekaert professional.