The effective date of the Governmental Accounting Standards Board s (GASB) new lease guidance is drawing nearer. Private sector companies also have recently adopted significantly revised lease guidance; although some details differ, the overriding refrain is not to underestimate the time and resources needed. Depending on the number of leases and variability of contract terms, implementation can be a significant undertaking. The effort needed demands a clearly defined action plan. Do not wait to start or you may not be able to properly comply with the new rules. Collaborating early and often with your advisors and audit firm will help avoid any unpleasant surprises. Schedule regular time to evaluate progress and discuss challenges, judgments and conclusions. Whether or not you are an audit client, BKD can help. Effective Date Statement No. 87, Leases Reporting periods beginning after December 15, 2019 Key Provisions Statement 87 reflects GASB s belief that all leases are financings and creates a single, symmetrical model for lessees and lessors. The new rules eliminate distinctions between operating and capital leases and treat all leases as financings (similar to today s capital lease accounting). Lessees and lessors must disaggregate lease and nonlease components within a single contract and contracts with multiple lease components. Significant new disclosures are required. To assist with adoption, GASB is expected to release a Leases Implementation Guide in June 2019. This will clarify, explain or elaborate on almost every aspect of the new guidance, including scope, definition of a lease, lease terms, disclosure, incentives, multiple components, modifications and terminations, subleases, intra-entity and related-party leases. For a comprehensive overview of GASB s lease requirements, see BKD s white paper, New Rules on a Government s Accounting for Leases. Lessees Substantially all leases will be recognized on the lessees statement of net position. For operating leases (which today are not reported on the statement of net position), lessees will be required to recognize an asset for the right to use the leased item and a corresponding lease liability. Lease liabilities will be considered long-term debt, and lease payments will be capital financing outflows in the cash flow statement. In the activity statement, lessees will no longer report rent expense for today s operating-type leases, but will instead report interest expense on the liability and amortization expense related to the asset. All leases will result in the recognition of interest and amortization expense, and all lease commitments will be recognized as liabilities. Lessors Lessor accounting will mirror lessee accounting. Lessors will recognize a lease receivable and a corresponding deferred inflow of resources with certain exceptions while continuing to report the asset underlying the lease. Interest income associated with the receivable will be recognized using the effective interest method. Lease revenue will arise from amortizing the deferred inflow of resources in a systematic and rational manner over the lease term. The new rules exclude leases associated with investment assets carried at fair value, e.g., investment rental property, which will continue to be accounted for as they are today. GASB is eliminating the direct-financing and sales-type lease categories under Statement 87.
Entitywide Education Is Key Individuals throughout the organization will need to understand the new lease accounting rules because they represent a fundamental change from current guidance. As highlighted below, finding leases will require crossfunctional effort. Certain staff outside the accounting department will need a high-level understanding of the rules to ensure population control. Who negotiates the leases? Who sells the leases? Who manages the leased assets? Who pays for the leases? BKD has various webinars and BKD Thoughtware available at bkd.com, or you can schedule BKD to host an education session. Project Governance Establishing an appropriate governance and project management structure is critical. Meetings and communications should include representatives from planning and development, engineering, public works, metropolitan development, public safety, information services, procurement, legal and, of course, finance, to name a few. Identify a champion or team to lead adoption efforts and work directly with the auditors. Some questions to consider in assessing the size and scope of implementation plans include: How many different types of lease transactions exist? Where are lease contracts stored? What level of detail is maintained on lease terms? What systems are used to manage lease data? Ensure your finance staff can handle the necessary implementation tasks in addition to their regular duties. Consider hiring additional resources or consultants for the project. Contemplate training needs to implement new processes. Scoping Lease Population Statement 87 has an updated lease definition: a contract that conveys control of the right to use a non-financial asset (the underlying asset) for a period of time in an exchange or exchange-like transaction. Right to use includes both the right to obtain the present service capacity and the right to determine the nature and manner of use. Statement 87 replaces the term agreement under current guidance with the term contract to require that a lease whether written or verbal is legally enforceable. Contracts for services are not leases. Some governmental contracts transfer the right to use an asset for only a nominal amount, e.g., one dollar per year, in exchange for the right to use the underlying asset. These would be considered a nonexchange transaction, which will continue to be covered by Statement No. 33, Accounting and Financial Reporting for Nonexchange Transactions. Limited exceptions to the guidance are provided for short-term leases (those lasting a maximum of 12 months at inception, including any options to extend), financed purchases, leases of assets that are investments and certain regulated leases, e.g., between airports and air carriers and other aeronautical users. 1 Additional exclusions 1 This exception is available to lessors whose leases are subject to certain external laws, regulations or legal rulings that establish all of the following: a. Lease rates cannot exceed a reasonable amount, being subject to determination by an external regulator b. Lease rates should be similar for lessees that are similarly situated c. The lessor cannot deny potential lessees the right to enter into leases if facilities are available, provided the lessee s use of the facilities complies with generally accepted use restrictions 2
include contracts for intangible assets, biological assets, inventory, service concession arrangements and supply contracts such as power purchase agreements. Statement 87 does not include a quantitative threshold exception for lower-value leases. Under GASB s general materiality guidelines, if the underlying assets are insignificant individually and in the aggregate this statement s provisions may not apply. However, entities establishing a lease capitalization policy similar to that of capital assets are cautioned because the significance of asset capitalization is independent of the assessment of the significance of liability recognition. Review scope conclusions with your auditor. Most governments already have capital leases, so the accounting is relatively straightforward for the operating leases that will now be reported on the statement of net position. The greatest challenge for most governments will be finding the lease population and all the necessary data. Governments with a standardized contract process and a centralized repository likely will have an easier time identifying lease contracts. Data challenges include: Data housed in various systems and operating units Lack of resources Information is not all in one agreement Number of new data elements required Information may not be contained in lease agreements, e.g., the fair value of an asset, the asset s estimated useful life or the incremental borrowing rate Embedded Leases Do not forget about embedded leases. Governments regularly enter into contracts that cover both the right to use an asset and paying for an asset s maintenance services. Examples of this include leasing a building and paying for maintenance services or leasing copiers and paying for print management services or maintenance services all in one agreement. Identifying and collecting the contracts that may contain embedded leases can be tricky as they likely will not be labeled as a lease. For embedded leases, governments must determine if the required payments can be broken down between the lease and nonlease components. If not, the entire agreement must be treated as a lease. This likely will be a significant change for many governments as these types of agreements were often treated as operating leases in the past. See Appendix A for examples of potential embedded leases. Since almost all leases will be recognized on the statement of net position, an entity s judgment in distinguishing between leases and services becomes more critical under the new guidance. System Requirements Current lease IT systems primarily focus on lease management rather than accounting and usually handle real estate leases. Today, many governments use spreadsheets to track leases and prepare required disclosure and accounting evaluation. Given the comprehensive accounting and disclosure requirements of the new standard, governments likely will need to supplement their current IT systems or implement new IT systems to address Statement 87 requirements. Governments with a small lease portfolio may be able to leverage their existing manual processes or IT systems; however, a large portfolio of leases may require significant technology investment. In addition to the initial implementation, consider the effect of ongoing disclosure and remeasurement requirements. For some governments, a hybrid approach may be the best option selecting a leasing system for a significant portfolio of real estate and property leases and executing a manual process for an insignificant amount of equipment leases. 3
Analysis of In-Scope Leases After the lease contracts have been identified, governments will need to measure those contracts correctly to properly account for them. Evaluation and documentation of contract terms are critical. The determination of lease payments may seem straightforward; however, it can be complex and affected by factors including but not limited to security deposits, bargain and other purchase options, residual value guarantees, minimum annual (payment) guarantees, variable components, e.g., payments based on an index, etc. The standard requires more management judgment than previous guidance. Key management judgments include the determination of the lease term, discount rate and amortization period. Significant judgments should be properly documented and reviewed with auditors. Internal Control & Policy Considerations Existing controls will need to be re-evaluated and most likely enhanced for the identification of leases (including embedded leases); evaluation of lease contracts; classification, measurement and recognition of right-of-use (ROU) assets and lease liabilities; evaluation of related estimates; and preparation of disclosures. Policies that may require development or revision include: Capitalization thresholds for reporting leases Framework that addresses reasonably certain for the lease term determination Process to identify contracts that could contain embedded leases going forward Allocation process and procedures for a contract s nonlease components Controls to identify remeasurement triggers 2 Governments might want to consider differentiated materiality thresholds based on the class or location of lease transactions. Lease portfolios can be differentiated in multiple ways; a common example involves differentiating between real estate leases and equipment leases. IT System Controls Governments implementing a system solution to comply with the new standard s requirements also will have to assess the related system risks and design and implement related internal controls, such as logical access, change management and segregation of duties; application controls, such as those that maintain data integrity for the lease information captured, the accuracy of lease expense computations, ROU asset amortization, interest expenses, etc.; and as applicable, secure and accurate integration with other systems, e.g., accounts payable, and data transfers from one system to another or from the subledger to the general ledger. Quantitative disclosures may require additional controls because the necessary information is not readily available through an entity s standard lease process. Governments also should consider that disclosures may be populated from multiple systems, i.e., some disclosures may come from the lease system and others may be populated through the general ledger; as such, new controls may need to be implemented in or around multiple financial reporting systems. Governments should review initial conclusions on the adequacy of internal controls with their auditors. 2 a. Change in lease term b. Change in likelihood of certain payments being required c. Change in rate lessor charges lessee (if used as a discount rate) d. Change in contingency of variable lease payments variable to fixed payments 4
Financial Statement Presentation Retroactive application to all prior periods presented is required, using the facts and circumstances that exist at the beginning of the period of implementation or earliest year presented. The statement includes GASB s standard language if practicable. However, if a government has all the lease data for the current year, it would be very hard to argue it would not be practicable to restate the prior period. Lessor governments that previously derecognized underlying assets under Statement 62 s guidance for sales-type or direct-financing leases are not required to determine the underlying asset s value at the time of implementation and recognize it. Instead, any residual asset included in the net investment in the lease should become the new carrying value of the underlying asset. In the first restatement period, the notes to the financial statements should disclose the restatement s nature and effect and the reason for not restating prior periods, as applicable. Note also that disclosure requirements have been enhanced and expanded under Statement 87 to provide information about the full cost of leases. Have your auditor sign off on the financial statement presentation format. Communication with External Users Governments will need to educate lenders, municipal bond investors and analysts, rating agencies and other financial statement users to ensure they understand the changes to financial information upon adoption. Entities must provide visibility and transparency to stakeholders, including the effect on debt ratios that could result from the addition of a large number of new liabilities formerly recorded only in footnotes as operating leases. Public & Private Sector Differences The changes in both GASB and Financial Accounting Standards Board (FASB) lease guidance will create additional challenges in comparing entities that can be either publicly or privately owned, such as a utility, hospital, college or university. For example: ROU assets may amortize more quickly than the liabilities under the GASB model, negatively affecting net position. Under the FASB model, the asset and liability amounts will generally equal each other throughout the lease term FASB entities will report lease liabilities as long-term operating payables. GASB entities will report these liabilities as long-term debt, heightening concerns about compliance with restrictive debt covenants FASB entities will continue to report straight-line rent expense (similar to current rules). GASB entities will report interest expense on the liability and amortization expense related to the asset, thus front-loading expense recognition In cash flow statements, lease payments will be classified as capital financing outflows by GASB entities and operating outflows by FASB entities Debt Covenants/Statutory Debt Limits Careful examination of the effects of increased leverage and potential debt covenant violations will be required. Due to the unique terms of indenture clauses and varying state legislation, legal counsel may be required to determine if lease obligations are considered debt for debt service calculations or debt limit provisions. 5
Conclusion For some governments, the adoption of Statement 87 will be complex and likely will require significant hours to implement correctly. Proper documentation throughout the implementation process is critical to a smooth yearend audit. Schedule time with your advisors and/or audit firm to sign off on all key adoption concepts. BKD can help educate your team, provide implementation tools and assist with analysis and documentation. If you would like assistance complying with the new guidance, contact your trusted BKD advisor. Contributor Anne Coughlan Director 317.383.4000 acoughlan@bkd.com 6
Appendix A Embedded Leases 7