Capital & Operating Leases

ODJFSOffice of Fiscal & Monitoring ServicesBureau of County Finance & Technical Assistance

OJFSDA Conference, June 2009

Agenda Understanding the differences

between operating and capital leases

Understanding criteria to determine lease type

Building leases

Agenda

Recording lease activity

Disposition of leased assets

Summary

Operating Leases An operating lease is similar to rent:

it is for a stated portion of time (less than the useful life)

no ownership occurs from the relationship

rental costs are not directly associated with the acquisition cost of an asset

Capital Leases

Capital leases are similar to a financed purchase:

an asset is essentially being purchased

the lease payment effectively consists of both principal and interest

calculations

Capital Leases

the market value of the asset is capitalized and interest is imputed over the lease term

the capitalized value is depreciated over the asset’s useful life

Determination of Lease Type

Capital Lease versus Operating Lease1. Lease conveys ownership to the lessee at some

point

2. The lessee has an option to purchase the asset at a bargain price

3. Term of the lease is 75% or more of the useful life of the asset

4. Present value of the minimum lease payments equals or exceeds 90% of the fair value

Determination of Lease Type

Additional Criteria Lessee has a bargain renewal option that

is sufficiently lower than fair rental value

Beginning of the lease term falls within the last 25% of the useful life of the asset

Determination of Lease Type

Additional Criteria -

Bargain Renewal Option

A bargain renewal rate is one that is sufficiently lower than the fair rental of the property at the date the option becomes exercisable

Determination of Lease Type

Additional Criteria -

Bargain Renewal Option

If there is a bargain renewal option, the lease criteria for points # 3 and # 4 must be recalculated to include the extended lease term and the additional minimum lease payments

Determination of Lease TypeAdditional Criteria –

Leasing used assets

When the beginning of the lease falls within the last 25% of the useful life of the asset, comparisons of lease term to useful life as well as present value of minimum lease payments to fair value are irrelevant (points # 3 and # 4)

Only points # 1 and # 2 should be reviewed in determining lease type

Determination of Lease Type

Criteria # 1:

The lease conveys ownership to the lessee during or at the end of the lease term

if ownership is transferred at any time, the lease is a capital lease and must be depreciated

Determination of Lease Type

Criteria # 2: The lessee has an option to purchase the

asset at a bargain price at the end of the lease term if the lessee has the option of a bargain

purchase, then the lease is a capital lease and must be depreciated

bargain purchase options exist when the purchase price is significantly below market value of the asset

Determination of Lease Type

Criteria # 3: The term of the lease is 75% or more of

the useful life of the asset

if the lease term is 75% or greater of the

useful life as defined by the least restrictive useful life table (either county or DAS), the lease is a capital lease and must be depreciated

Determination of Lease Type

Criteria # 4: The present value of the minimum lease

payments equals or exceeds 90% of the fair value of the leased asset

if the present value of the minimum lease payments is 90% or more of the fair value of the lease, the lease is a capital lease and must be depreciated

Determination of Lease Type

Additional Criteria - Bargain Renewal Option

The lease contains a bargain renewal option that renews the lease at a sufficiently lower than fair rental value of the asset

the lives of both leases (original and renewal) are combined when evaluating point # 3

the minimum lease payments of both leases are combined when evaluating point # 4

Determination of Lease Type

Additional Criteria - Leasing Used Assets

The beginning of the lease term falls within the last 25% of the useful life of the asset (eliminates bullet points # 3 and # 4 as items of consideration)

Determination of Lease Type

Additional Criteria - Leasing Used Assets

only points # 1 and # 2 need to be reviewed in determining lease type

if at the inception of the lease, 75% or more of the asset’s useful life has been consumed and points # 1 and # 2 are not applicable, the lease is an operating lease and the payments are expensed

Building Leases

County family service agencies cannot own property and therefore, must enter into operating leases for office space

Building leases may be between the agency and another entity or between the agency and the county (“Less-Than-Arm’s-Length” transaction)

Building Leases

Lease or rental payments are allowable claims to federal programs and must be reasonable; criteria to consider for reasonableness should include:

rental costs of comparable property market conditions in the area alternatives available the type, life expectancy, condition, and value

of the property leased

Building Leases

Operating leases need to be reviewed periodically to ensure the lease rates are reasonable

at a minimum, before lease renewals

Building Leases – “Less-Than-Arm’s-Length” Transaction

Where one party to a lease agreement is able to control or substantially influence the actions of the other party

Claimable costs are limited to those that would be allowable if title to the property was vested in the county agency

Building Leases – “Less-Than-Arm’s-Length” Transaction

Allowable costs are generally limited to depreciation, use allowance, maintenance, taxes, insurance, and related interest

Acquisition costs (less cost of land) are claimable as depreciation over the useful life of the asset on a straight line basis

Building Leases – “Less-Than-Arm’s-Length” Transaction

Demolition costs of an existing building on the site of a new building are not acquisition costs; they become part of the basis in the land

Building Leases – “Less-Than-Arm’s-Length” Transaction

Records supporting building lease rate should include: acquisition costs

land and demolition costs (segregated from acquisition costs)

renovation, capital improvements, and addition costs

allocation of costs among multiple tenants

Building Leases – “Less-Than-Arm’s-Length” Transaction

The depreciable life of the building is based on the useful life utilized for financial reporting purposes

the useful life should never be based on the bond life used for financing the purchase of the building

Building Leases – “Less-Than-Arm’s-Length” Transaction Documentation of Building Arrangements

an official agreement between the local agency and the county should exist defining the responsibilities of both the local agency and the county in relation to the building; this agreement should include terms of occupancy and the financial arrangements for the building’s use and related costs

Recording Lease Activity Operating Lease:

payment is an operating expense and should be charged to either the appropriate cost pool or benefiting program

Recording Lease Activity

QuIC+ Coding - Operating Lease:

010, 020, 030 - Account # 529205(Cost Pool – Operations)

-or-

Program Project # - Account # 531002(Project – Equipment Lease)

Recording Lease Activity

Capital Lease:

payment is a combination of principal, interest and other operating costs

the market value of the asset at the beginning of the lease is depreciated over its useful life

Recording Lease Activity

Capital Lease:

charges such as insurance, maintenance fees, etc. are operating costs and should be charged to either the appropriate cost pool or benefiting program

Recording Lease Activity

Capital Lease:

interest is an operating cost and should be charged to either the appropriate cost pool or benefiting program

principal is charged to local dollars; the asset’s full market value is charged to local dollars over the life of the asset

Recording Lease Activity QuIC+ Coding - Capital Lease

Principal portion of payment: Project # 899 - Account # 531002

(Non-Reimbursable Expenditures – Equipment Lease)

The effective cost of the equipment will berecorded over the life of the lease

Recording Lease Activity QuIC+ Coding - Capital Lease

Interest portion of payment:Project # - Account # 529205(Cost Pool or Program – Operations)

Ancillary charges portion of the payment: Project # - Account # 529205(Cost Pool or Program – Operations)

Recording Lease Activity Capital Lease:

depreciation is an operating expense and charged to either the appropriate cost pool or benefiting program over the asset’s useful life based on a straight line basis

an off-setting entry for depreciation is also recorded as a negative expenditure to local dollars over the asset’s useful life

Recording Lease Activity QuIC+ Coding - Depreciation

Depreciation of capitalized value: Positive Entry:

010, 020, 030 - Account # 529205

(Cost Pool – Operations) -or-

Program - Account # 592003(Project # – Equipment Depreciation / Use Allowance)

Recording Lease Activity QuIC+ Coding - Depreciation

Depreciation of capitalized value:

Negative Entry:

899 - Account # 592003

(Non-Reimbursable Expenditures – Equipment Depreciation / Use Allowance)

Local expenditures are effectively reimbursed

for the cost of the asset over its useful life

Disposition of Leased Assets Operating

assets are returned to the lessor and financial obligation normally ends

Capital assets may or may not be returned to

the lessor, depending on the terms of the lease

disposition of assets need to be recorded on inventory and fixed asset records

gain or loss needs to be calculated and duly reflected in financial reporting

Disposition of Leased Assets

Regardless of lease type, benefits received and incurred losses on the disposition of assets are normally applied to the benefiting program or cost pool

In Summary…

Upon entering into a lease agreement, agencies need to determine if the lease is an operating or a capital lease

After evaluating the four main criteria, there are two additional criteria which also needs to be considered as part of the determination

In Summary…

Agencies need to properly classify and code lease transactions

Operating

normal operational cost

In Summary… Agencies need to properly classify and

code lease transactions

Capital

market value of asset at the beginning of lease term

imputed interest rate

In Summary… Agencies need to properly classify and

code lease transactions

Capital

ancillary charges portion of payment

amortization of principal and interest portion of payment

useful life of asset

In Summary…

Building Leases: Carefully define terms of the lease

understand conditions of a “Less-Than-Arm’s-Length” transaction

composition of building costs

In Summary…

Building Leases: Carefully define terms of the lease

methodology for determining allowable and reasonable rental costs

allowable use of building

financial arrangements for building costs

In Summary…

Additional Questions