Process Group/Policy Details
Subject: Treasury Accounting
Title of Policy: Capital Lease
Effective Date: 07/01/2014
Approved/Revision Date: 07/01/2014
Approved by: State Controller
In This Policy
Process Group Description
Capital Lease Accounting
The process group Capital Lease Accounting provides the ability to record accounting entries for events that occur when a lease agreement is entered into which qualifies for a capital lease.
Rationale or background to policy:
Governmental accounting standards require special treatment of governmental fund capital leases as outlined in GASB Statement No. 62. The objective of the policy is to reflect on the fund level operating statement, the source and use of funds related to the financing arrangement that resulted in the entity recording a capital asset and related lease liability on the government-wide financial statements.
LEASE CLASSIFICATION
1) Definitions
Capital lease. CRS 24-30-201(l) defines a capital lease as defined in generally accepted accounting principles issued by the governmental accounting standards board that the controller prescribes for the State as specified in section 24-30-202(12
Fair value of leased property. The price for which the property could be sold in an arm’s length transaction between unrelated parties. This price should reflect any volume or trade discounts that may be applicable. GASB Statement No. 62, paragraph 271.
Lease. A lease is an agreement conveying the right to use property, plant, and equipment (PP&E) for a stated period of time. GASB Statement No. 62, paragraph 211.
Lease purchase agreement. CRS 24-82-801(4) defines a lease purchase agreement to be a capital lease as defined in generally accepted accounting principles issued by the governmental accounting standards board that the controller prescribes for the State as specified in section 24-30-202(12). A lease purchase agreement has the same meaning as a capital lease, which is defined in generally accepted accounting principles.
Lessee incremental borrowing rate. The rate that, at the inception of the lease, the lessee (State agency) would have incurred to borrow over a similar term the funds necessary to purchase the leased asset. GASB Statement No. 62, paragraph 271. In the absence of a recent borrowing of matching term upon which to base the lessee’s incremental borrowing rate, State agencies should use the State Treasurer’s pooled cash earnings rate, not the lessor’s rate.
Minimum lease payments. The payments that the lessee is obligated to make or can be required to make in connection with the leased property. GASB Statement No. 62, paragraph 271. Minimum lease payments include rent for the equipment, “executory costs” made to the lessor (e.g. maintenance, insurance, or taxes), the bargain purchase option (which allows the lessee to buy the asset at a predetermined price below fair value), guaranteed residual value (a type of insurance protecting the lessor against an unexpected decline in the value of the asset), and any penalties for failing to renew or extend the lease.
2) Lease classification under GASB Statement No. 62
Generally accepted accounting principles. The State of Colorado shall use generally accepted accounting principles – GASB Statement No. 62 to determine the classification of a lease. GASB Statement No. 62 classifies leases as either operating or capital. Operating leases do not have characteristics of ownership and minimum lease payments are expended or expensed. Capital leases have characteristics of ownership and the related assets are capitalized and depreciated over the expected useful life of the asset.
Capital lease. Under GASB Statement No. 62, a lease is classified as a capital lease if, at its inception, it meets any one of the following four criteria:
Ownership transfer. The lease transfers ownership of the property to the lessee by the end of the lease term.
Bargain purchase option. The lease contains a bargain purchase option. This is defined as, “A provision allowing the lessee the option to purchase the leased property for a price which is sufficiently lower than the expected fair value of the property at the date the option becomes exercisable and that exercise of the option appears, at the inception of the lease, to be reasonably assured.” GASB Statement No. 62, paragraph 271.
75% economic life. The lease term is equal to 75 percent or more of the estimated economic life of the leased property. The lease term is defined as the “fixed non-cancellable term of the lease plus (i) all periods, if any, covered by bargain renewal options.” GASB Statement No. 62, paragraph 271.
Present value-90% fair value. The present value of the minimum lease payments at the inception of the lease, excluding executory costs, equals at least 90 percent of the fair value of the leased property.
Operating lease. Under GASB Statement No. 62, A lease is classified as an operating lease if, at its inception, it does not meet any one of the four criteria in §2b above.
3) Determining fair value under GASB 62
Methods for fair value. If fair value based on selling price is not readily available (for example a significant time lapse between the lessor’s acquisition of the property and the lease inception, or lease of a portion of a building), then other methods of determining fair value may include appraisals, relying on sales of similar assets, estimated replacement cost information, estimates using discounted cash flows, or estimates using the income approach.
When using a valuation method other than selling price, the lessee prepares a comparison of alternate fair valuation methods, assumptions used for each method, and a justification for using the proposed valuation method.
All underlying assumptions should be reasonable and based on present market valuations.
Lease of a partial building. When leased property is part of a larger property, its cost and fair value may not be objectively determinable. In this case, the lessee determines the fair value of the entire building. Then the lessee multiplies the fair value of the entire building by the percentage of leased space to total space to determine the fair value of the leased space. Adjustments should be made for any attribute of the leased space that makes its value significantly higher or lower than other space in the building. This provides for an equitable comparison between the present value of the minimum lease payments and the fair value of the leased property.
4) Lease modifications under GASB 62
For all lease modifications, State agencies will need to complete an analysis to determine prospective lease classification. The time period to be analyzed will depend on whether the modifications are related to a renewal/extension or changes in the lease provisions.
Renewal or extension. An existing lease is considered a new agreement when it is renewed or extended beyond the original lease term without any other changes in the lease provisions. The exercise of a renewal option included as part of the original lease term (e.g., an option period for which exercise was reasonably assured because of a termination penalty) is not a renewal or extension of a lease. State agencies shall apply the criteria in §2 to classify the new agreement using the terms of the new agreement as they exist at the date of the change.
Example. If a 5-year lease is extended by 5 years with no other changes to the lease provisions, the 5-year extension is considered a new agreement. The criteria of §2 is applied to the 5-year extension, including other factors (interest rate, fair value and estimated residual value) as they exist at the date of the extension. The results of this test determine the classification of the new agreement.
Modifications other than by renewal or extension. When lease provisions are changed in a manner that would have resulted in a different classification of the lease had the new terms been in effect at the original inception date, the revised lease is considered a new agreement. As a new agreement, State agencies shall apply the criteria in §2 to classify the lease modification using the revised terms of the lease over its remaining life including other factors (interest rate, fair value, estimated residual value, etc.) as they exist at the date of the change. Examples of changes in lease provisions that would result in changing the classification of a lease include increases or decreases in the rental payments, adding or removing bargain purchase options, and adding or removing transfers of ownership. Changes in lease provisions do not include changes in estimates, such as changes in the estimates of the economic life or residual value of the lease property.
Example. If the monthly rent under a 60-month lease is changed from $1,000 per month to $1,200 per month effective for the remaining 36 months of the lease, the lease should be re-evaluated using the lease classification criteria in §2 as if the original lease required 24 monthly payments of $1,000 and 36 monthly payments of $1,200. All other factors (e.g., interest rate, fair value, estimated residual value) used for purposes of this analysis would remain unchanged. If, as a result of the re-evaluation, it is determined that applying the modified lease payments would have resulted in a capital lease rather than an operating lease at its original inception date, then the revised lease is considered to be a new agreement. The criteria of §2, should then be applied to the revised lease, evaluating the lease over its remaining useful life as of the date of the change, using all provisions as they exist at that date. The result of the second analysis determines the classification of the new agreement.
5) Factors other than GASB Statement No. 62 to determine whether a lease is operating or capital
Structuring the transaction. State agencies shall use business judgment to structure the transaction so that the lease provides the best value to the State. The best value could be either an operating or capital lease depending on a number of factors:
Factors favoring operating lease. Examples of factors that favor an operating lease may include high technology, rapid change, short expected useful life of the asset, short-term use, financing period that is less than the asset’s useful life. Examples of these types of assets include copiers, office equipment, computer equipment, and buildings which the State intends to occupy for the short-term.
Factors favoring capital lease. Examples of factors that favor a capital lease may include slow rate of technological or usage change, expected long asset useful life, long-term use, and financing period that approximates or exceeds the asset’s expected useful life. Examples of these types of assets include production equipment and buildings where the State intends to occupy for the long-term.
Uncertainty. If there is uncertainty about the classification of a lease, State agencies should base their analysis on the substance of the transaction rather than the form. One key question to ask is whether the State agency has taken on the risks and benefits of ownership.
6) Series of operating leases. State agencies are required to present to the Capital Development Committee the reasons why the State agency has not entered into a lease purchase agreement for leased property when all of the following are met: 1) the State agency has entered into a series of operating leases for real property, 2) the State agency is planning to continue leasing the real property, and 3) over the entire series of operating leases the State has expended 100% the fair value of the asset.
7) Appropriation required.
Real property. Under CRS 24-82-801(1)(a), lease purchase agreements (capital leases) for real property with total payments greater than $500,000 shall be specifically authorized by a special bill approved by the General Assembly
Personal property. Under CRS 24-82-801(1)(a), lease purchase agreements (capital leases) for personal property with total payments greater than $500,000 shall be specifically authorized by an annual general appropriation act, supplemental appropriation act, or special bill approved by the General Assembly.
Annual rentals. Rentals subsequent to approval by the General Assembly as provided in §7a and §7b may be made from the capital construction or operating section of an annual general appropriation act or supplemental appropriation act.
8) Exception to appropriation. The following are excluded from §7 above: Colorado Department of Transportation, Institutions of Higher Education, and State Treasurer.
9) State Controller approval. Under CRS 24-82-801(3), the State Controller shall approve all lease purchase agreements with total payments greater than $500,000. For leases with total payments less than $500,000, a State agency may have the Office of the State Controller review the classification analysis.
10) Issuance of instruments
Lease purchase agreements may provide for issuance of instruments evidencing rights to receive rentals and other payments made by the State, but only if the payments are made subject to annual appropriation and authorized by a special bill or other substantive legislation which does not include bills solely related to appropriations.
Lease purchase agreements shall not include any evidence of indebtedness of the State.
11) Accounting for leases under GASB 62
Operating leases. For operating leases, rent is treated as an operating expense/expenditure, which is recognized in the financial statements over the time the asset is used. The leased asset and lease liabilities are not recognized in the balance sheet accounts on the financial statements.
Capital leases. For capital leases, the related assets are reported in the balance sheet accounts on the financial statements as if they had been purchased. The assets and their accompanying liabilities are capitalized either by recognizing the present value of the minimum lease payments, or the value of the leased assets, whichever is the lower. The leased asset is depreciated in the same way as if the asset had been purchased, while its associated liabilities decrease as the lease payments occur.
Fiscal Procedures Manual. See the Fiscal Procedures Manual for further information on the accounting for leases.
Policy Statement:
Departments shall record capital lease activity in accordance with these policies and procedures within 30 days of closing on the obligation. Departments shall record all capital lease activity using GAX General Accounting document for outflows, FA for fixed asset and depreciation, and JV1TRES (standard journal voucher) document for accounting only transactions.
Procedure(s):
TA.PR.04.1 Initial Entry for Capital Lease-Purchases
Direct Method. The direct method of purchasing records the asset directly onto the State’s balance sheet accounts once the asset is acquired.
Governmental Funds
Event Type XT09 is used to record capital lease liability and all subsequent capital lease accounting activity for governmental funds using the direct method. Under modified accrual, a capital lease is recorded as Capitalized Property Purchase expenditure and an Other Financing Source in fund 1000. Then, in fund 4710 the Capitalized Property Purchase expenditure and Other Financing Source balances are reversed and the asset and payable are recorded.
Posting codes within event type XT09 facilitate recording of the non-budgetary entries of Future Capital Lease Payments revenue and Capital Lease purchase Expenditure in fund 1000 and the reversal in fund 4710. The asset will be recorded through use of a manual shell FA document in the Fixed Asset module. See AM.PR.01.2.
Proprietary Funds
Event Type XT11 is used to record capital lease liability and all subsequent capital lease accounting activity for proprietary funds (including internal service funds) using the direct method. Posting codes for event type XT11 record the asset and the Lease Liability. Financing Method. The financing method uses cash received or held in custody by a Trustee for the construction of an asset. As construction progresses, expenditures are recorded within a specific balance sheet account until construction is completed.
Governmental Funds
Event Type XT10 is used to record capital lease liability and all subsequent capital lease accounting activity for Governmental funds using the financing method.
Proprietary Funds
Event Type XT11 is used to record Capital Lease Purchases for Proprietary funds using the financing method.
TA.PR.04.2 Capital Lease using Governmental Funds; accrual process
The process of converting transactions from modified to full accrual for financial reporting purposes is recorded with the original liability event type XT09 or XT10. SEE TA.PR.04.1.
TA.PR.04.3 Capital Lease payment process
Capital lease payments will be made using a GAX standard payment document. Liability reduction will occur using the JV1TRES and posting codes within the Event Type applicable to the original liability entry. SEE TA.PR.04.1.
TA.PR.04.4 Capital Lease year-end process
The JV1TRES will be use to record year-end events for Capital Leases. The year-end events include reclassifying long-term liability to current and accrual of interest expense payable. All of these accounting entries will be accomplished using the Event Type applicable to the original liability entry. SEE TA.PR.04.1.