There has been a lot of material in the marketplace about the new lease standards. Up until this point, the majority of this has been focused on the new FASB guidance, ASC 842. For individuals at organizations that have been following some of the ASC 842 requirements, we thought it would be helpful to highlight some of the key differences between the requirements of ASC 842, Leases, and GASB 87, Leases. Below are five notable differences between GASB 87 and ASC 842.
1) Effective dates:
The new standard for governmental organizations, GASB Statement No. 87, Leases, is effective for reporting periods that begin subsequent to December 15, 2019. For example, adoption of the standard is required on January 1, 2020 for calendar years ending December 31, 2019. As most governmental entities have annual reporting requirements, government entities have until the end of their 2019 fiscal year to implement the policies and processes needed to comply with new rules on accounting for leases.
Public companies were required to adopt ASC 842 for annual reporting periods (including interim periods) beginning after December 15, 2018. Calendar year public companies were required to adopt as of January 1, 2019. For private companies, the FASB recently announced an extension, in which adoption for calendar-year companies can be delayed until January 1, 2021.
2) Definition of a lease:
Per GASB 87, Leases, Paragraph 4: “A lease is defined as 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 an exchange like transaction.” Per ASC 842-10-15-3: “A lease is defined as a contract that conveys the right to control the use of an identified asset for a period of time in exchange for consideration.”
One key difference in the definition of a lease is that GASB 87 requires an “exchange or exchange-like transaction,” compared to ASC 842, which requires an “exchange for consideration.” Therefore, there may be instances where you have a lease under ASC 842, but not a lease under GASB 87. The example below highlights this difference.
A lessee leases the right to full use of an office building for 3 years. The building has a market rent of $10,000 per month, however, the parties agreed to lease the building at a rate of $1,000 per month. Does this meet the definition of lease under GASB 87 and ASC 842?
Under GASB 87
No. This does not meet the definition of lease under GASB 87 because this is not an “exchange-like transaction.” The fact that the lessee is leasing the asset at a rate substantially under the market rate results in a “nonexchange” transaction, and therefore, is not a lease under GASB 87.
Under ASC 842
Yes. With the facts presented here, all criteria are met for this contract to be defined as a lease. The lessee has the right to control the full use of the office building for a specified period of time. The fact that the rent payment is substantially below market rent does not impact the definition of a lease under ASC 842.
3) Ownership provision
Per GASB 87, Leases, Paragraph 19: “A contract that transfers ownership of the underlying asset to the lessee by the end of the contract and does not contain termination options . . . should be reported as a financed purchase of the underlying asset by the lessee or sale of the asset by the lessor.”
Per ASC 842: Since transfer of ownership is one of the tests to determine lease classification, a transfer of ownership provision impacts the classification of the lease, resulting in a finance lease.
An ownership provision in the contract will have a significant difference in the accounting for the agreement between the two standards. The key difference here is that under GASB 87 the transfer of ownership indicates you do not have a lease, but rather a financed purchase arrangement for a lessee or a sale of the asset by the lessor. In contrast to ASC 842, in which the transfer of ownership provision results in a finance lease.
4) Definition of control:
Per GASB 87, Leases, Paragraph 5: Control is defined as “the right to obtain present service capacity” and “the right to determine the nature and manner of use.” Per ASC 842-10-15-4: Control is defined as “substantially all economic benefits” and “the right to determine the nature and manner of use.”
One key difference regarding the definition in control is how substitution rights impact the control assessment. Now, let’s look at an example and evaluate it based on the requirements of each standard: A contract allows a vendor to replace the underlying asset with an identical asset. Does this right of substitution affect the evaluation of control of the asset from the lessee’s perspective?
No. the substitution right does not affect the control assessment for the lessee. This is because the lessee still maintains the service capacity to use the underlying asset regardless of the substitution right.
Yes. This right does affect the control assessment and additional evaluation is necessary to determine if this arrangement is a lease. The lessee must determine if the lessor would economically benefit from the substitution. Per ASC 842-10-15-10, “The supplier would benefit economically from the exercise of its right to substitute the asset (that is, the economic benefit or economic incentive from substituting the asset is expected to exceed the costs of substituting the asset.)” In plain English, if the vendor has the right to substitute the asset, and must benefit economically from doing so, this represents a substantive substitution right, and therefore, the contract is not a lease.
5) Financial reporting classification and impact to EBITDA
All leases are classified as finance leases and the lease liability is classified as long term debt. IFRS 16 classifies leases in a similar manner. Therefore, the adoption of the new standard will have an impact on an entity that evaluates EBITDA, since the interest associated with the lease is classified as “interest expense” (whereas an operating lease historically would not have had interest expense recognized). Separately, the depreciation of the asset is classified as a “depreciation expense” on the balance sheet.
Leases are classified as finance, previously referred to as capital, or operating leases. Please note that the accounting for capital leases is unchanged, however, capital leases are now called finance leases because all leases will now be capitalized. The accounting for operating leases has changed significantly, due to the fact that operating leases will need to be capitalized on the balance sheet. Lessees will need to record a “Lease Liability” and an “ROU Asset,” in order to capitalize operating leases on the Balance Sheet. However, under ASC 842, the recognition of an operating lease on the Balance Sheet will not affect EBITDA, as the lease liability is classified as operating payables. The amortization of the ROU asset will be recognized as amortization expense.
Hopefully, this helps summarize some of the key differences between lessee accounting under ASC 842 and GASB 87. For more resources about FASB, IFRS, and GASB lease accounting, visit the lease accounting resources page.