In this video we are talking about a huge accounting change that is happening right now. GASB 87. And I will be explaining why it is so important. WATCH NOW
In the United States, we have two main accounting standards, GASB and GAAP. GASB is the accounting standards for government organizations and GAAP is the accounting standards for business. The business world is constantly changing. Every year new accounting standards are released that update how we do accounting.
Now if you are watching this, and you work in private business, you might be thinking, “Why do I care about a GASB pronouncement? I only care about GAAP.” You might want to stick around to watch this video. Because what ends up happening, is the accounting standards boards will roll something out in GASB first to test it out before they roll it out for GAAP. So even if you work in private business, you should be paying attention to what is happening with GASB 87. Because it may be coming for you next.
The new standard is called GASB 87, and it is about leases. This is one of the biggest accounting changes we have seen for a very long time. Without getting into the details, leases were previously expensed on the income statement, and now they are recorded as long-term liabilities on the balance sheet. Basically, it is taking, what was previously off-balance sheet transactions, and putting them onto the balance sheet.
This is an enormous amount of work. For many organizations, they have hundreds of lease documents. Each one needs to be reviewed, analyzed, and booked in the accounting records. For most accounting departments, who barely have enough staff to put together the annual financial report, this is an incredibly difficult task. So, you must ask yourself, why are we putting ourselves through so much pain, to make a drastic change?
To understand the reason behind GASB 87, you must understand one of the central concepts in business. Everything in business revolves around bond markets. Once you understand this concept, everything in business makes more sense. Bond markets are the foundation of the investment world. Everything is built on top of bond markets. Bonds are the most stable, least risky, most boring investment out there. For that reason, it forms the basis for most large portfolios. It provides a safe place you can put your money and get back a very predictable amount of interest income. On top of the bond market, you have all these other types of investments like stocks, options, derivatives, currencies, commodities, all of which are more risky, more exotic, and more interesting, but also less reliable.
Large organizations spend a lot of time paying attention to bond markets and their credit rating. The credit rating determines their access to capital markets. A great business provides a way to use capital to fund a business model that will make money for everyone, including your investors.
In the government world, government bonds are a big business. The government uses bonds to build schools, roads, and utilities around your city. This allows the government to fund very large projects and pay off the interest over time with tax dollars.
That brings us back to GASB 87. You must think, “What is GASB 87 doing?” It is affecting your liquidity and solvency ratios, which is assets compared to liabilities. Liquidity is captured with the current ratio which equals current assets divided by current liabilities. This tells you if you can make your immediate debt payments. Solvency looks at the longer term. Solvency is captured with the Debt-to-Equity ratio which equals total debt divided by total equity. This tells you if the amount of leverage being used by an organization is sustainable in the long-term. If you are a bond investor; liquidity and solvency are the most important ratios. It is generally preferable to loan money to people who have less liabilities.
For example, imagine you lending money, and you have a choice between two different people. Both people have the same amount of assets. But one person has very little debt, while the other has an enormous amount of debt. All things being equal, you would rather loan your money to the person with very little debt, because there is less risk of them not paying you back. For the person with a lot of loans, you must worry if they are going to be able to make all those debt payments.
When we talk about leases, there are some organizations with a lot of buildings. These are brick and mortar buildings that they are paying long-term agreements for. Previously, these agreements were not included on the balance sheet. That makes it very hard to compare with an organization that may not have very many leases. Just imagine two organizations, one with a lot of buildings and one with no buildings. Previously, both organization’s balance sheets would look the same, because leases were not on the balance sheet. But that is not true reflection of what is going on. One organization has a lot of debt.
We are entering a new era, where you do not necessarily have to use a lot of buildings to operate a successful business. You can have an entirely online organization. You want to be able to be compared against other organizations on an equal footing so you can show how effectively investor’s capital is being put to work.
Even though GASB 87 is difficult, it is very important. For something that is usually a huge expense for many organizations, leases are something that significantly impact liquidity and solvency ratios. It makes financial statements more accurate, and easier for bond investors to use. Anything that makes capital markets more efficient is a good thing.
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Neither Zach De Gregorio or Wolves and Finance shall be liable for any damages related to information in this video. It is recommended you contact a CPA in your area for business advice.