What are short-term leases?
Short-term leases are any leases with a maximum lease term of 12 months. That includes options to extend, regardless of intent to exercise those options.
Thus, if both parties can cancel during some part of the lease term without cause, and neither party needs the other’s permission, this part of the term is excluded from the max possible term for the purpose of determining the lease’s status as short-term.
However, if only one party can cancel during a certain part of the term, that part is included in the max possible term for the purpose of determining the lease’s status as short-term.
For example, a City leases an asset from a State for 18 months, but the City can cancel after eight months. The State cannot. Since only one party can cancel, the max lease term is 18 months.
However, imagine both parties can cancel after eight months. The remaining ten months are excluded when determining the lease category. This makes it a short-term lease.
Month-to-month leases are considered short-term.
How to account for short-term leases
The lease accounting is fairly simple. The lessee records an expense each time they make a lease payment to the lessor. Meanwhile, the lessor records revenue each time they receive one of these payments from the lessee.
For example, if a City leases an asset from a State with a $1,000 monthly lease payment, the City will record a $1,000 cash outflow each month. Meanwhile, the State will record a $1,000 cash inflow to account for receiving the lease payment.
Short-term leases don’t require any additional disclosures under GASB 87.
What are regulated leases?
A lease becomes a regulated lease if there are external laws, court rulings, or regulations that impact how that lease contract can be designed.
An airport-airline agreement is a classic and perhaps the most common example of a regulated lease. In fact, paragraph 42 of GASB 87 recognizes that the Department of Transportation and Federal Aviation Administration regulates airport-airline agreements and similar leases.
Still, airline leases are only considered regulated if they are for aeronautical use, per the FAA’s definition.
If they are not for aeronautical use — such as for terminal concessions or hotels — then they may be considered for non-aeronautical use. Non-aeronautical leases or components of leases may not be considered regulated, subjecting them to regular GASB 87 guidelines if not short-term.
How to account for regulated leases
Many types of leases must follow the accounting rules laid out in GASB 87, but they are not necessarily regulated leases.
Instead, lessors may be able to recognize revenue based on the individual contract’s payment provisions.
However, the laws, regulations, or rulings that make this lease “regulated” must meet the following criteria as laid out by GASB 87:
- Lease rates cannot exceed a “reasonable” amount. What constitutes “reasonableness” is determined by an external regulator
- Lease rates should be similar for lessees that are similarly situated
- The lessor cannot deny potential lessees the right to enter into leases if facilities are available, provided that the lessee’s use of the facilities complies with generally accepted use restrictions.
GASB 87 requires entities to disclose several pieces of information about certain regulated leases. These include a general description of the leasing arrangements, total resource inflows or outflows recognized under these agreements per reporting period, a schedule of expected future payments, and more.
Contracts that transfer ownership
As the name implies, a contract that transfers ownership is a lease agreement that transfers the asset at the lease’s end and does not contain termination options or an additional purchase price
These contracts can contain cancelation or fiscal funding clauses if the parties are reasonably certain that these clauses will not be exercised.
For example, Entity A leases a building from Entity B under a lease-purchase agreement. After Entity A makes all of the required monthly rental payments, they will gain ownership of the asset at the end of the lease term. If the agreement included an additional purchase option, such as a $1 or FMV purchase option, the agreement would not be considered a contract that transfers ownership. Instead it would still qualify as a GASB 87 lease (assuming all other requirements are met), regardless of the reasonable certainty to exercise the purchase option.
How to account for contracts that transfer ownership
Contracts that transfer ownership should be treated as an asset sale from the lessor’s perspective and an asset purchase on credit from the lessee’s perspective.
Returning to the lease-purchase example: Entity A, the lessee, will record the purchase of the building from the lessor on credit. Meanwhile, Entity B — the lessor — will record a sale of the building to the lessee.
All other leases
Any lease contracts that do not fall within any of the specific lease categories we discussed are categorized under a single model called All Other Leases.
These should be considered leases and should comply with all of the applicable requirements of GASB 87.
Accounting for all other leases
For all other leases, the lessee must recognize a right-of-use asset and related lease liability.
The lessee measures the liability at the present value of the total lease payments. The asset is recorded at an amount equal to the liability plus any payments made to cover direct costs before or at lease commencement.
Meanwhile, the lessor recognizes a lease receivable and a deferred inflow of resources at lease commencement.
Lessors measure the lease receivable as the present value of the payments they expect to receive over the lease term. Meanwhile, they calculate the deferred resource inflow as the lease receivable plus any lease payments received before or at lease commencement.
Next, lessees amortize the asset systematically, such as with the straight-line method. This occurs over the lease term or asset’s useful life, whichever is shorter.
Each period, lessees make lease payments that partially reduce their lease liability. Simultaneously, the lessee calculates and recognizes interest expense based on the lease balance and the contract’s implicit interest rate. The lessee can use an incremental borrowing rate if the implicit interest rate is not easily known.
Additionally, the lessor mirrors this process. Lessors reduce the deferred inflow of resources by recognizing lease revenue inflows, and they recognize interest revenue.
As for disclosures, the lessee needs to provide a description of the lease agreement, resource inflows amounts, historical cost, and accumulated amortization information across leases by lease asset class, as well as principal and interest payments — reported separately — for the next five years. They must also disclose expected principal and interest thereafter in five-year increments.
The lessor will have similar disclosures mirrored to reflect the role as the lessor, although lessors won’t have an amortization disclosure for obvious reasons.
