GASB 87 Implementation: Embedded Leases, Discount Rate, Disclosures

GASB 87 implementation is the process by which a state or local government brings its leases onto the statement of net position as right-to-use assets and corresponding liabilities, replacing the older operating-versus-capital split. The standard treats every qualifying lease as a financing arrangement for the right to use a nonfinancial asset. It took effect for fiscal years beginning after June 15, 2021, following an 18-month postponement by GASB Statement No. 95.¹ Implementation itself comes down to four jobs: identify every qualifying contract, measure the liability and asset, present the numbers in the right places, and keep the inventory current as contracts change.

What Qualifies as a Lease

A lease under this standard is a contract that gives your government control over the right to use another party’s nonfinancial asset for a set period, with both sides exchanging roughly equal value. Nonfinancial assets are tangible things: buildings, vehicles, heavy equipment, land. Control has two parts. You get the benefit of using the asset throughout the contract, and you decide how it gets used within the terms of the agreement.²

The word “lease” does not need to appear anywhere in the contract. What matters is whether the arrangement gives your entity the right to use an identified asset. A multi-year service agreement built around a specific piece of equipment may still be a lease.

Several categories fall outside the standard:

Short-term leases, meaning any lease with a maximum possible term of 12 months or less including all extension options, whether or not you plan to exercise them. Payments under these are recorded as expenses when due.²
Contracts that transfer ownership at the end of the term. Those are financed purchases.
Intangible assets. Software licenses, patents, and similar items are excluded; cloud subscriptions follow GASB 96.
Biological assets such as timber and livestock.
Assets held as investments.
Supply contracts and inventory arrangements.
Certain regulated leases with their own treatment.²

Finding Embedded Leases in Service Contracts

This is where most implementation teams miss things. An embedded lease is a right-to-use arrangement hidden inside a contract that looks like a service agreement. A waste removal contract with a dedicated dumpster, a managed print contract that places specific copiers in your offices, a warehouse arrangement where your agency controls a defined area — each of these can contain a lease component subject to GASB 87 even though nobody called it a lease when the ink dried.

Run every service contract involving physical assets through four questions. Does the contract identify or implicitly dedicate a specific asset to your use? Do you receive all the benefit from that asset during the contract period? Do you control how the asset is used? Is there an exchange of value? Four yeses and a term over 12 months mean you probably have an embedded lease that needs to be separated from the service component.

Procurement and legal are the right places to start hunting, since they negotiate and execute the agreements. Cross-reference their contract list against accounts payable to catch anything that was never flagged. The discovery effort is front-loaded. Once the initial inventory is built, keeping it current takes far less work.

Building the Contract Inventory

Pull together every active contract that could contain a lease. Gather physical documents and digital records, then extract what you need for measurement: the exact start date, the payment schedule, escalation clauses, and any options to extend or terminate early.

Extension and termination options matter because they affect the lease term. If it is reasonably certain your government will exercise an extension, include those additional years in the calculations.³ Capture fixed payments, variable payments tied to an index or rate, and any residual value guarantees. Note lease incentives such as rent-free periods or upfront cash from the lessor, because those reduce the value of the right-to-use asset.

Review past board meeting minutes and purchase orders to catch agreements that were never formally tracked as leases. Assign each contract a unique identifier so the audit trail stays clean. Most agencies use dedicated lease accounting software or detailed spreadsheets, and the right choice depends on portfolio size. A dozen leases will fit in a spreadsheet. Several hundred will not.

Setting a Capitalization Threshold

GASB 87 does not set a dollar threshold below which you can skip capitalizing a lease. The Board acknowledged that governments can establish their own capitalization policies for leases, similar to those already used for capital assets, as a practical way to operationalize materiality. Those threshold decisions belong to management and are not prescribed by the standard itself.⁴

Whatever number you choose, document the rationale and apply it consistently. The Board also cautioned that a threshold policy does not eliminate the need to assess whether omitted leases are significant in the aggregate. Twenty leases sitting just under your threshold can add up to a material amount.

Measuring the Liability and Right-to-Use Asset

The lease liability equals the present value of payments you expect to make during the lease term. That includes fixed payments, variable payments tied to an index or rate, and amounts reasonably expected under residual value guarantees.²

The right-to-use asset starts at the same amount as the lease liability, then gets adjusted. Add any payments made to the lessor before the lease started, plus any direct costs your agency incurred to put the asset into service. Subtract lease incentives received from the lessor. The result is the net cost of your right to use the asset.²

After initial recognition, each lease payment splits into two pieces: interest expense on the outstanding liability and a reduction of the principal balance. The liability shrinks as principal is paid down. The right-to-use asset is amortized in a straight line over the shorter of the lease term or the useful life of the underlying asset, and that amortization appears as an expense similar to depreciation on assets you own outright.²

Picking a Discount Rate

The discount rate follows a hierarchy. Start with the rate the lessor charges you, meaning the rate implicit in the lease. If that rate is not readily apparent from the contract, use your government’s estimated incremental borrowing rate, which is essentially what a lender would charge your entity to borrow the same amount for a similar term. Some agencies use the rate on their most recent comparable debt issuance, others consult their banking institution, and others reference the prime rate published by the Federal Reserve. Whichever approach you take, be prepared to document and defend it during the audit. Auditors push back hard when the source of an incremental borrowing rate cannot be explained.

Remeasurements, Modifications, and Terminations

Lease balances are not recalculated every year for the sake of it. The standard requires reassessment of the lease term only when something concrete changes:

Your government exercises an option to extend or terminate that was previously considered unlikely.
Your government decides not to exercise an option that was previously considered likely.
A contract-specified event triggers an automatic extension or termination.²

Modifications, meaning actual amendments to the contract, are handled separately. If an amendment gives your government access to an entirely new asset and the price increase is reasonable, treat it as a separate lease. Otherwise, remeasure the existing liability using the revised terms and adjust the right-to-use asset by the difference between the new liability and the old one. If the adjustment would push the asset value below zero, recognize the excess as a gain.⁴

Terminations work similarly. Reduce both the liability and the asset and record any difference as a gain or loss. The distinction between exercising an existing option (remeasurement) and amending the contract (modification) trips up many preparers. Exercising an extension option already written into the contract is a remeasurement event. Negotiating new terms is a modification.⁴

Transition and Retroactive Application

The standard calls for retroactive application. If practicable, restate financial statements for all prior periods presented. If restatement is not practicable, report the cumulative effect as a restatement of beginning net position for the earliest period shown. Either way, measure existing leases using the facts and circumstances that existed at the beginning of the period of implementation, not the original commencement date.⁴

The Board was clear that “inconvenient” does not equal “not practicable.” Make a genuine effort to restate before concluding it cannot be done. If prior-period restatement is skipped, the notes must explain why and describe the nature and effect of the adjustment.

Presentation and Disclosures

Lease assets and lease liabilities appear as separate line items on the statement of net position, distinct from owned capital assets and other long-term debt. Separation is the whole point. Readers should be able to tell at a glance how much of the balance sheet comes from lease arrangements versus outright ownership.

Required lessee note disclosures include:

A general description of your leasing arrangements, including the basis and terms of any variable payments.
The total amount of right-to-use assets and accumulated amortization, broken out by major class of underlying asset.
A schedule of future lease payments showing principal and interest separately for each of the next five fiscal years, then in five-year bands after that.²

If your government also leases property or equipment to others, lessor accounting under the same standard requires you to recognize a lease receivable and a deferred inflow of resources at the start of the lease term, and to disclose a description of the leasing arrangements and the total inflows recognized from leases. The underlying asset stays on your books.²

Where Software Subscriptions Fit

Cloud software subscriptions do not fall under GASB 87. GASB Statement No. 96 covers subscription-based information technology arrangements (SBITAs), contracts that convey the right to use a vendor’s IT software for a set period. The mechanics closely mirror GASB 87, but the scope is different. GASB 96 applies to software; GASB 87 applies to tangible, nonfinancial assets.⁵

The practical impact for your inventory is sorting agreements into the right bucket. A lease for a physical server rack goes to GASB 87. A subscription to a cloud-hosted financial management platform goes to GASB 96. A contract bundling a tangible asset with a significant software component may need to be split between the two standards. Contracts with a tangible asset and only a trivial software component stay entirely under GASB 87.

Common Mistakes to Avoid

A few errors show up repeatedly. Missing embedded leases is the most common. Agencies build their inventory from the contracts labeled “lease” and stop there, overlooking service agreements that contain dedicated assets. The second most frequent problem is choosing a discount rate without documentation. Auditors will press hard if you cannot explain where your incremental borrowing rate came from and why it is reasonable for each lease’s term and amount.

Third, many agencies underestimate the ongoing maintenance. GASB 87 is not a one-time exercise. Every new contract signed, every option exercised, and every amendment negotiated requires revisiting the calculations. Building that review into your year-end close from the start is far easier than scrambling once the auditors flag something.

1
Governmental Accounting Standards Board. Summary – Statement No. 95
2
Governmental Accounting Standards Board. Statement No. 87 – Leases
3
Governmental Accounting Standards Board. Implementation Guide No. 2019-3, Leases
4
Governmental Accounting Standards Board. Statement No. 87 of the Governmental Accounting Standards Board
5
Governmental Accounting Standards Board. Summary – Statement No. 96