New Accounting Standards Could Disrupt Access to Financing

Additions to the accounting standards released by GASB in June of 2017 are a dramatic shift, requiring organizations to begin planning now. The lease accounting changes, similar to new FASB standards, mean all leases will now be on the balance sheet for the first time. This includes operating leases, which previously were only reported as expenses in the income statement and as footnote disclosures.

The new standard is effective for periods after December 15, 2019. This means that if your year-end is December, your organization will apply these starting with the December 31, 2020 financials. If your fiscal year ends in June, you’ll need to apply this starting July 1, 2020.

This seems like a long way off, but the changes are sweeping enough that it’s wise to start looking into how it will impact your organization. Besides all the work in implementing the new standards, government finance teams need to reach out to their lenders and other stakeholders as soon as possible. The new lease standards may change your organization’s balance sheet, and that may disrupt your access to financing. 

What GASB 87 Will Do to Balance Sheets

Every lease your organization has will now appear on the balance sheet. At inception, lessees will recognize a lease liability, which will be recorded as the present value of future lease payments. Lessees will also record a corresponding intangible asset that represents the lessee’s right to use the asset under lease. The initial value of this intangible asset will equal the lease liability adjusted for any additional pre-payments, costs to put the asset into service and any lease incentives received from the lessor.

For leases already in place at the transition date, lease liabilities and the corresponding intangible asset can be measured using the remaining lease payments. This means that organizations won’t have to track down old leases and recalculate the original liability as if GASB 87 had been in place since inception.

Organizations with many operating leases will see the biggest changes to their balance sheets, and may see their liabilities increase substantially. Operating leases include leases for office or warehouse space, school bus fleets and equipment. If your organization doesn’t have many leases, the impact will likely be minimal.

Many government finance officers are surprised to learn that long-term service contracts may also include embedded leases, so it’s essential to analyze all contracts. You may find you have more leases than you thought. In fact, on average, organizations find up to 10 times the number of leases they originally expected.

A recent clarification from GASB specifies that for disclosure purposes, lease obligations don’t fall under the definition of debt. Future payments on lease liabilities will still be disclosed in the footnotes, but separately from other forms of debt. However, it’s unclear whether banks and other financial institutions will follow suit and exclude lease liabilities from their definitions of debt.

Because of the lack of clarity, it’s essential that government finance teams get started as soon as possible to begin assessing the impact on their financials, and to begin discussing that impact with lenders and other stakeholders.

Here are some of the ways that GASB 87 may have an impact on a governmental entity’s borrowing capacity:

Debt Limitations

Limitations on the debt that governments can assume are determined variously by state constitutions and state statutes. Limitations may be formulated as absolute dollar amounts, or may be calculated as a percentage of revenues or as a percentage of the valuation of taxable property in a jurisdiction. In some states, voters need to approve any new debt.

For example, for New York counties and municipalities, debt is limited to a percentage of a five-year-average of the full valuation of taxable property. Texas, on the other hand, limits debt service to 5% of the average general revenue for the previous three years.

Adding to the complexity, some states, such as California, explicitly exclude lease agreements from debt limitations, while others include annual lease payments as part of the entire debt load. However, it should be noted that most—if not all—of the relevant statutes and state court decisions refer to capital leases, and not to operating leases. It’s not yet clear whether states will follow GASB and treat operating leases the same way they treat capital leases.

The lack of standard treatment across the country means that government finance officers will need to consult with legal counsel to determine whether the additional liabilities from operating leases will be included in the calculation of their debt limits.

Bond Covenants

Bond issue contracts may include covenants that forbid governmental entities from issuing additional bonds or taking on other debt unless certain conditions are met. They may also require that certain financial ratios related to debt coverage be maintained. If this applies to your situation, you may need to consult with legal counsel to determine whether additional liabilities from operating leases might violate those covenants.

Violation of bond covenants may be considered a technical default, and may result in a downgrade of that bond’s rating from a credit rating agency. In turn, this may lead to an increase in borrowing costs.

However, some of the credit rating agencies already consider lease payments from footnote disclosures in their credit scoring, so the new standard could have little impact.

Loan Covenants

Some governments finance projects with bank loans. As mentioned above, it’s not clear whether banks will follow GASB’s lead to exclude lease liabilities from the definition of debt.  

This means that an organization that leases office space could violate bank loan covenants when that lease shows up on the balance sheet. Government finance officers may need to renegotiate terms of bank loans so this doesn’t happen by surprise.

Uncertainty ahead

Will the new lease standards have an impact on your organization’s access to financing?

So far, the answer is maybe. This uncertainty adds to the urgency for government finance teams to begin the work to implement the new standards as soon as possible. It’s a steep learning curve, and discussions with your lenders and legal counsel will be essential.

Education is key. Remember that time is ticking and the complexities behind this new standard will take you time to get your arms around, so you may not have as much time as you think you do.