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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
Recommended