Capital & Operating Leases

Capital & Operating Leases ODJFS Office of Fiscal & Monitoring Services Bureau 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 Lease • Lease conveys ownership to the lessee at some point • The lessee has an option to purchase the asset at a bargain price • Term of the lease is 75% or more of the useful life of the asset • Present value of the minimum lease payments equals or exceeds 90% of the fair value

Determination of Lease Type AdditionalCriteria • 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 AdditionalCriteria - 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 AdditionalCriteria - 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 Type AdditionalCriteria – 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 AdditionalCriteria - 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 AdditionalCriteria - 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 be recorded 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

Capital & Operating Leases