FINANCIAL WATCH By Bill Bosco GASB Takes on a Project to Change Lease Accounting There Is Risk That It Will Cause the Cost of Municipalities’ Debt to Increase O If enacted as proposed, the new rules would have a bigger impact on real estate transactions and would also negatively affect debt rating, the cost of debt and the availability of credit for state and local government municipalities. N NOV. 11, 2014, the Governmental Accounting Standards Board (GASB) issued a Preliminary Views document on a project to change current GASB lease-accounting GAAP that would conform with the proposed approach in the soon-to-be-completed Financial Accounting Standards Board (FASB)/International Accounting Standards Board (IASB) Leases project. March 6, 2015, was the comment period deadline. The preliminary views from the GASB include following the IASB single-lease model for lessees and a direct finance, lease-only model for lessor accounting. Some expert com-mentators believe this approach would obscure the finan-cial results of municipalities. If enacted as proposed, the new rules would have a bigger impact on real estate transactions and would also negatively affect debt rating, the cost of debt and the availability of credit for state and local government municipalities. Yet another concern is that the GASB ap-proach differs from that of the FASB in the Leases project, which ELFA and other organizations support as best repre-senting the economics of lease transactions in the financial statements of lessees and lessors. FASB/IASB Proposal The main objective of the current FASB/IASB Leases pro-ject is for lessees to capitalize all operating leases, other than short-term leases, as an asset and liability. The FASB and IASB are not converged on lessee accounting. The IASB would adopt a model that capitalizes all leases, which the GASB follows, with this proposed change. The FASB retains risks-and-rewards–based lease-classification tests in place (with minor changes to remove the “bright lines” present in the FAS 13 classification tests) and treats capitalized operat-ing leases differently from capital leases. Under the FASB approach, the operating lease cost is the straight-line rent expense and the operating lease liability is reported as an “other” liability—not debt. The capitalized lease asset is also separately reported as a right–of-use asset. Regarding lessor accounting, both the IASB and FASB have decided that current GAAP should not change in any material way. The GASB, on the other hand, is proposing to eliminate the operating lease method for governmental enti-ties that act as lessors. The only area where there appears to be significant municipal leasing as a lessor is in real estate— either as an owner/lessor or a sublessor. The idea of lessor accounting for lease of a part of a building (such as excess office space) as a direct finance lease is not practical as the fair value and residual value are not readily determinable; as such, one cannot calculate the implicit rate in the lease. Background The current GASB accounting rules incorporate the FAS 13 lease-accounting rules virtually verbatim. Briefly, under both the FASB and GASB rules, lessees account for leases as either operating leases (off-balance-sheet with straight-line rent expense) or capital leases (on-balance-sheet as a depre-ciating asset and a liability with imputed interest). Lessors account for leases as either direct finance leases (receivables and residuals are the leased assets and finance lease revenue is recognized using the interest method) or operating leases (leased asset is a depreciable asset and rents/residuals are the revenue elements). Also, the GASB rules disregard fiscal funding or cancellation clauses for lessee lease classification and financial reporting purposes if the possibility of cancel-lation is remote. Fiscal funding clauses are present in leases that qualify as tax exempt (i.e., lessor’s revenue is exempt from federal income taxes), also known as municipal leases, which are the most common type of equipment leases em-ployed by municipal government entities. These leases are classified as capital leases (on-balance-sheet as a physical as-set and debt) under current GASB GAAP. Typically, operat-ing leases entered into by municipalities involve office space or other real estate leases. They are off-balance-sheet under current GASB GAAP as they are executory contracts under U.S. bankruptcy rules, and, as such, do not create an asset or debt in a bankruptcy liquidation. GASB Proposed Approach The GASB proposes that lessees apply capital lease account-ing to all leases. It would label the resulting asset an “intan-gible” asset contrary to the tangible asset that results under current capital lease accounting. The proposed P&L lease cost is front-loaded , as interest is imputed on the liability. The liability is considered debt for all leases. Analysis reveals that such a change by the GASB would not impact ELFA member government lease lessee behavior, as the vast majority of government leases are tax-exempt leases, which, by definition, are capital leases. This means they should all be capitalized now under current GASB GAAP. What would be impacted are the reported results of newly capital-46 MARCH/APRIL 2015 EQUIPMENT LEASING & FINANCE MAGAZINE