CSOP 9.0 Capital Lease Agreements

SUBJECT:

Capital Lease Agreements

SOURCE:

Financial Accounting Standards No. 13 Accounting for Leases

ORIGINAL DATE

OF ISSUE:

March 2010

DATE OF

LAST REVISION:

December 2014

CSOP NO:

9.0

RATIONALE:

To provide guidelines for the capitalization of lease purchases.

CSOP:

 

 
Type of Lease:  Capital or Operating
Generally Accepted Accounting Principles (GAAP) Capital Lease Criteria

Review of Capital Lease Criteria

Amortization Schedule
Lease Requisition/Purchase Order
Asset Information for Requisition
Capital Lease Accounting
Asset Returned to Vendor
Release of Obligation
Leases Involving Land, Buildings, or Real Estate

 

Type of Lease:  Capital or Operating

A lease is a contractual agreement conveying the right to use property, plant or equipment for a specified period of time.  A lease agreement involves at least two parties, a lessor and a lessee.  The lessor agrees to allow the lessee to use the property, plant or equipment for a specified period of time in return for periodic payments.  There are two types of leases; an operating lease and a capital lease.

 

Operating Lease

An operating lease includes a lessor who collects rent, and a lessee who uses the property, plant or equipment and pays periodic payments for such use.  The lessee merely uses the equipment.  There is no risk or benefit of ownership.  Payments for an operating lease are charged to expense.

 

Capital Lease

A capital lease transfers substantially all of the benefits and risk inherent in ownership to the lessee.  The lessee accounts for this type of lease as an acquisition of both an asset and related liability.  If an asset is determined to be a capital lease, assets will be created regardless of the University’s $5,000 capitalization threshold. 

 

Generally Accepted Accounting Principles (GAAP) Capital Lease Criteria

Per FAS 13, “If substantially all of the benefits and risk of ownership have been transferred to the University, the lease should be accounted for as a capital lease.  Substantially all of the benefits and risk of ownership have been transferred when one of the following four criteria has been met:” 

 

  1. The lease transfers ownership to the lessee by the end of the lease term.
  2. The lease contains a bargain purchase option.  Exercise of the option must appear reasonably assured at the inception of the lease.
  3. The lease term is equal to 75% or more of the estimated economic life of the property, and the beginning of the lease term does not fall within the last 25% of the total economic life of the leased property.
  4. The present value (PV) of the minimum lease payments at the beginning of the lease term is 90% or more of the fair value of the leased property.  The interest rate, used to compute the PV, should be the incremental borrowing rate of the lessee unless the implicit rate is available and lower.

 

If none of the above are met, the lease should be classified as an operating lease. 

 

Review of Capital Lease Criteria

The lease transfers ownership to the lessee by the end of the lease term. 

Within the title section of the lease will be wording that will communicate if title will transfer such as, “Lessee shall have title to the equipment immediately upon delivery and shall be deemed the owner of the equipment.”  If any wording such as this is present, then this criterion has been met and the lease agreement should be accounted for as a capital lease.   

 

The lease contains a bargain purchase option.  Exercise of the option must appear reasonably assured at the inception of the lease. 

The lessee might see wording similar to the following, “Provided the lessee is not in default, upon expiration of the scheduled term, the lessee shall have the option to purchase the equipment for $1.00.”  If any wording such as this is in the lease and it is reasonably assured that the bargain purchase option will be exercised by the lessee, then this criterion has been met and the lease should be accounted for as a capital lease. 

 

The lease term is equal to 75% or more of the estimated economic life of the property and the beginning of the lease term does not fall within the last 25% of the total economic life of the leased property.

The estimated economic lives used at IU are based on the asset type codes.  The list can be found here.  The calculation used for this criterion divides the lease term in years by the useful life of the leased equipment. 

 

Example:

Lease term of 4 yrs/Useful life of 5 yrs=80%, criterion met.

Lease term of 3 yrs/Useful life of 5 yrs=60%, criterion NOT met.

 

Please note:  The above assumptions are based upon the lease of new equipment.  If the lease is for used equipment, Office of Procurement Services will be required to determine the remaining life of the equipment being leased.  If the remaining life of the leased equipment is in the last 25% of its useful life, this criterion will not be met. 

 

The present value of the minimum lease payments at the beginning of the lease term is 90% or more of the fair value of the lease property. 

The interest rate, used to compute the PV, should be the incremental borrowing rate of the lessee unless the implicit rate is available and lower.  The fair market value (FMV) is the amount the lessee would have paid for the property if it was purchased.  It is the responsibility of the Office of Procurement Services to determine the fair market value used in this calculation.

 

An amortization schedule for the lease agreement will need to be obtained from the vendor.  The amortization schedule should include the monthly payment, principal, interest, number of payments and the interest rate used.  On a quarterly basis Treasury will supply the Capital Asset Office with the incremental borrowing rate for Indiana University.  The quarterly rate will be forwarded to the Office of Procurement Services to be used in the PV calculation. 

 

In the following example, the present value of the minimum lease payments is $8,162.29 which is greater than 90% of the FMV of $7,200.  The first example would qualify as a capital lease.  In the second example, 90% of the fair market value is $8,280 which is more than the PV of the minimum lease payments of $8,162.29.  The second example would not qualify as a capital lease under this criterion.

 

Due to the complexity of this calculation, a GAAP Capitalization Test spreadsheet is available.  Please contact the Capital Asset Manager in the Capital Asset Office for assistance with this calculation.

 

Amortization Schedule

The amortization schedule should clearly identify the purchase order number, interest rate, payment number, payment due date, monthly payment amount, principal, interest and the running balance. The amortization schedules should not include amounts paid for executory costs such as insurance and maintenance.  Below is a recommended format to be used by the vendor or financial institution when preparing an amortization schedule for the University.

 

 

PO

12345

 

 

 

 

Interest Rate

15.474%

 

 

 

 

Payment Number

Payment Due Date

Monthly Payment Amount

Principal

Interest

Running Balance

 

 

 

 

 

6,501.00

1

02/10/xx

226.87

136.80

90.07

6,364.20

2

03/10/xx

226.87

139.30

87.57

6,224.90

36

01/10/xx

226.87

224.38

  2.49

        0.00

 

Once a lease is determined to be capital, the Office of Procurement Services will submit a copy of the lease agreement, amortization schedule, and  GAAP Capitalization Test spreadsheet to the Capital Asset Manager in the Capital Asset Office for final approval.  The Capital Asset Manager is reviewing the lease agreement to make sure it is set up correctly in accordance with accounting standards.  If approved, the Capital Asset Manager will convert the amortization schedule into .csv file format for uploading into the Requisition in KFS.

 

Lease Requisition/Purchase Order

For invoice processing, the requisition/purchase order should include one line for principal and one line for interest for each payment on the amortization schedule and one line for the bargain purchase option amount, if a bargain purchase option is in the lease agreement.  Any amounts paid for insurance or maintenance costs should be set up on a separate line item or separate requisition.  These costs should never be included in the lease payments of principal and interest.  The principal and interest amount can be uploaded from the .csv file received from the Capital Asset Manager.  All principal payments should use object code 7099, all interest payments should use object code 4403 and the bargain purchase option should use object code 7099. 

 

When issuing a requisition/purchase order for a capital lease the Type of Recurring Payment will need to be set.   The Type of Recurring Payment is found under the tab titled Payment Info. 

 

Asset Information for Requisition

After adding the lease object code 7099 the requisition will require asset information. Proceed to the Capital Asset tab to submit required information.  Knowledge of the following will be needed to complete this section: Capital Asset System Type, Capital Asset System State, Capital Asset Item Detail, and Location information.   

 

CAMS System Type 

  1. Individual- Capital line items will create individual assets, based on quantity.
  2. One system- All capital line items combined together to make identical asset(s) with identical cost(s).
  3. Multiple Systems- Capital line items will be combined in different ways to create multiple assets with different costs.

A video tutorial on how to determine this can be found here: Filling out a REQ:  What Capital Asset system type do I choose?

 

System State

Select the CAMS System State of New.  The system state of New will indicate to the Capital Asset Management Office that invoices should create new asset(s) in the university asset database.  When line items will be added together to create a system asset, each of these line items should also be assigned New.

 

Capital Asset Transaction Type

Set the Capital Asset Transaction Type to Capital Lease.

 

Capital Asset Items/System Detail

Information needed to complete this section includes: asset description, location, and quantity of assets.  Any special notes about the asset can also be given in the designated text box.

 

Asset Description

It is important to submit an asset description that uniquely identifies the asset for inventory purposes.  Sometimes it can be as simple as copying the line item description.  With scientific equipment, however, sometimes this is not appropriate.  “Biological Safety Cabinet” provides a clearer description than “1300 type II A2 KV Rfp”, for the general user.

 

Location

The asset location (where the asset is going to be in use) is required to be entered on the Capital Asset tab.   For those assets located on campus, a building code and room number must be entered.  KFS will only accept room numbers from the approved database.  Using the search feature, if you do not see the desired room number, please select the closest entry available or the delivery location (if different).  Make a note of the different location in the asset description section.  If this asset is to be shared and will be moving between two locations, make a note of this in the asset description section as well.  This will allow the capital asset creator to add text to the asset in KFS giving the exact location of the asset.  The Office of Space Management may be contacted to modify the KFS database, if needed. 

 

For assets located off-campus, use the chart code of OC and enter the street address, city, state, postal code, and country of the asset’s location.   Remember to hit the “Add” button to save your location information. 

 

A PDF of building codes and addresses can be found here: http://www.indiana.edu/~spaceinf/docs/IU-buildings.pdf

 

Capital Lease Accounting

Accounting for capital lease agreements involves the creation of a lease liability and a corresponding capital asset.  The lease liability and asset should be recorded at an amount equal to the present value of minimum lease payments or the fair market value, whichever is lower.  In most instances, this should equal the total principal amount found on the amortization schedule. 

 

The Capital Asset Manager will create the asset and liability with a Distribution of Income/Expense (DI) document in KFS.  The From entry to object code 7099 creates the lease liability and automatically creates the corresponding lease liability in the plant fund account to object code 9603. As invoices are paid, a debit to object code 7099 for principal and 4403 for interest will be posted.  The debit to object code 7099 will generate an entry to the plant fund account number on object code 9603.  The debit to object code 9603 will reduce the balance of the lease liability.  Upon the final payment of a lease, the liability balance will be zero.

 

Object Code

The To entry on the DI creates the capital asset and generates a capitalization entry in the plant fund account.  The object code chosen for the capital asset depends on the unit cost of the asset. 

 

Unit Cost over $5,000

If the unit cost of the capital asset is $5,000 or more, the asset should be tagged and inventoried.  The asset will be created using one of the following object codes:

7019 Capital Lease Equipment

7020 Capital Lease Computer Equipment

 

Unit Cost below $5,000

If the unit cost of the capital asset is less than $5,000, the asset may be tagged at the discretion of the organization.  Organizations are not required to tag or inventory leased assets with a unit cost less than $5,000.  The asset will be created using one of the following object codes:

7022 Capital Lease Equipment

7023 Capital Lease Computer Equipment

 

Asset Type Code

The useful life of the asset will be assigned according to the FAS 13 lease criterion that was met and the unit cost of the asset.  If the lease agreement met criterion number 1 or 2 and the unit cost of the asset is over $5,000, the asset will be depreciated by the university’s established useful life determined by the asset type code.  These assets will remain on the University’s books even after fully depreciated and the lease liability is paid in full since ownership is present in the lease agreement.  

 

Unit Cost over $5,000

If the unit cost of the asset is $5,000 or more and the lease agreement met criterion number 3 or 4, the asset will be depreciated over the term of the lease agreement.  Following is a listing of asset type codes based upon the lease term. 

 

 

Description

Asset Type Code

Useful

Life

12 Month Lease

90007

1

24 Month Lease

90008

2

36 Month Lease

90009

3

48 Month Lease

90010

4

60 Month Lease

90011

5

72 Month Lease

90012

6

 

Unit Cost below $5,000

If the unit cost of the asset is under $5,000, regardless of the lease criteria that was met, the useful life of the asset will equal the lease term.  Following is a listing of the asset type codes when the unit cost is less than $5,000:

 

 

Description

Asset Type Code

Useful

Life

12 Month Lease

90001

1

24 Month Lease

90002

2

36 Month Lease

90003

3

48 Month Lease

90004

4

60 Month Lease

90005

5

72 Month Lease

90006

6

 

When the asset is fully depreciated and the lease liability is paid in full, the asset will be retired by the University Capital Asset Office.

 

Monthly, the Capital Asset Manager for the University Capital Asset Office will reconcile each lease payment to the amortization schedules to ensure the correct amount has been applied toward principal and interest.  The Capital Asset Manager will research payment errors and will issue adjustments as needed. 

 

Asset Returned to Vendor

If an asset is returned to the vendor at the end of the lease, the organization must issue an Asset Retirement document in KFS with the reason of Discarded.

 

Release of Obligation

The department, at times, may work with the vendor to have the remaining lease balance waived.  It is the department’s responsibility to report to the Capital Asset Manager that the liability balance has been waived and no further payments will be made on the lease.    

 

The asset and liability amounts were created based on the total principal amount.  If the balance is waived and the leased asset will be retained, the remaining portion of the liability will be removed and recorded as a gift.  The Capital Asset Manager will issue a GEC to remove the remaining portion of the liability and record gift income.  For example:  A capital lease with a remaining lease balance of $4,500 is waived.  The organization is retaining the asset.  The GEC document will post the following entry to the general ledger. 

 

Account

Obj Cd

Debit

Credit

66-127-00

7099

$4,500

 

66-127-00

1175

 

$4,500

 

 

 

 

95-200-00

9603

$4,500

 

95-200-00

9899

 

$4,500

 

If the asset is returned to the vendor and the remaining lease balance is waived, the asset should be retired when the asset is picked up so that no more depreciation will take place.  A note should be included on the asset retirement document to inform the Capital Asset Manager that the leased asset is being returned to the vendor and the remaining balance of the lease agreement is being waived.  Upon receipt of the asset retirement document, the Capital Asset Manager will issue a GEC to remove the remaining liability balance.  When the asset is retired, any remaining net book value will post a loss to object code 4998 as a debit.  When the GEC is issued it will post a credit to object code 4997.  The 4998 and 4997 will offset each other on the income statement.

 

Leases Involving Land, Buildings, or Real Estate

Leases involving land only

If the terms of the lease indicate a transfer of title or contain a bargain purchase option, the University should account for the lease as a capital asset.  If the terms of the lease agreement do not transfer ownership or contain a bargain purchase option, the university should account for the lease as operating.

 

Leases involving land and buildings

If the terms of the lease indicate a transfer of title or contain a bargain purchase option, the University should account for the lease by separating the land and building, and capitalize separately.  The land and building should be separated based on the fair market value at the time of lease inception. 

 

If the term of the lease does not indicate a transfer of title or a bargain purchase option, the materiality of the land must be determined in relation to the total.  If the fair value of the land is less than 25% of the total fair value of the leased property, then the land is considered immaterial. 

 

Example:

Real Estate

FMV

Percentage

 

Land

  80,000

 20%

Land is immaterial

Building

320,000

 80%

 

Total

400,000

100%

 

 

 

 

 

Land

150,000

37%

Land is material

Building

250,000

63%

 

Total

400,000

100%

 

 

If the land is immaterial, the lease should be accounted for as a single building lease. 

 

If the land is material, the land and the building components should be separated.  The portion of the lease involving the land should be accounted for as operating.  The building portion will be capitalized if one of the following are met:  

  1. The term of the lease is 75% or more of the economic useful life of the building.
  2. The present value of the minimum lease payments equals 90% or more of the fair value of the leased real estate.

 

Leases involving real estate and equipment

If a lease agreement involves both real estate and equipment, the equipment and real estate should be accounted for separately. 

 

Leases involving only part of a building

If the fair market value of the leased portion can be determined, the University should account for the lease as described in “Leases involving land and buildings.”  If the fair market value of the leased portion cannot be determined, only the life criterion should be used to determine the lease classification.  If the lease is for a period greater than 75% of the life of the building, the lease is classified as a capital lease.  In all other instances, the University will account for the lease as operating.

DEFINITIONS:

Bargain purchase option-  A provision allowing the lessee the option of purchasing the leased property for an amount, exclusive of leased payments, which is sufficiently lower than the expected fair value of the property at the date the option becomes exercisable.  Exercise of the option must appear reasonably assured at the inception of the lease.  

Executory costs-  Costs excluded from minimum lease payments such as maintenance, insurance, and taxes. 

Implicit rate-  The interest rate that, when applied to the minimum lease payments, causes the aggregate present value to be equal to the fair value of the leased property to the lessor. 

Incremental borrowing rate-  The rate that, at the inception of the lease, the lessee would have incurred to borrow over a similar term the funds necessary to purchase the leased asset. 

Fair value of leased property, plant and equipment-  The property’s selling price in an arm’s length transaction between related parties.  The selling price is considered to be the cash option to purchase. 

Lease-  A contractual agreement conveying the right to use property, plant or equipment for a stated period of time. 

Minimum lease payments for the lessee-  The payments that the lessee is required to make according to the lease terms.  If the lease contains a bargain purchase option, only the minimum rental payments over the lease term and the bargain purchase are included in the minimum lease payments.

CROSS

REFERENCES:

GASB 34

GARS L20 Leases

RESPONSIBLE

ORGANIZATION:

Organizations that purchase capital assets with a lease agreement.