Standard Operating Procedures

SUBJECT: Capital Lease Agreements
SOURCE: Financial Accounting Standards No. 13 Accounting for Leases
ORIGINAL DATE OF ISSUE: March 2010
CSOP NO: 9.0
RATIONALE: To provide guidelines for the capitalization of lease purchases.
CSOP:
  1. Types of leases: Capital or Operating
  2. Generally Accepted Accounting Principles (GAAP) Capital Lease Criteria
  3. Review Each Capital Lease Criterion
  4. Amortization schedule
  5. Setting up a lease requisition/purchase order
  6. CAMS Document
  7. Accounting for capital lease agreements
  8. Vendor waiving the remaining debt of a capital lease
  9. Leases involving land, land and buildings, real estate and equipment and only part of a building
  1. Types of leases: 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.

    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.

    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.

  2. 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 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.

  3. Review Each Capital Lease Criterion

    • 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 taken from the American Hospital Association. 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 made based upon the lease of new equipment. If the lease is for used equipment, Purchasing 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 is the amount the lessee would have paid for the property if it was purchased. It is the responsibility of Purchasing 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 Purchasing to be used in the PV calculation.

      In the following example the present value of the minimum lease payments is $6,500.96 which is greater than 90% of the FMV of $5,400. In the second example the present value of the minimum lease payments is $6,500.96 which does not exceed 90% of the FMV of $6,750.


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

  4. Amortization Schedule

    Once a lease is determined to be capital, Purchasing will submit the amortization schedule and a copy of the GAAP Capital Lease Test spreadsheet to the Capital Asset Manager in the Capital Asset Office.

    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. Below is a recommended format to be used by the vendor or financial institution when preparing an amortization schedule for the University.


  5. Setting up a lease requisition/purchase order

    For invoice processing, the requisition/purchase order should include one line for principal, one line for interest and one line for the bargain purchase option amount, if a bargain purchase option is in the lease agreement. The principal and interest amount should be taken directly from the amortization schedule. The principal amount on line 1 should use object code 7099, the interest amount on line 2 should use object code 4400 and the bargain purchase option on line 3 should use object code 7099.

    When issuing a requisition/purchase order for a capital lease it is recommended that Type of Recurring Payment be selected first. This will insure the appropriate CAMS Tran Type is presented for selection. The Type of Recurring Payment is found under the tab titled Payment Info. Most capital leases will have a fixed interest rate and a fixed monthly payment. Therefore, the Fixed Schedule/Fixed Amount should be selected as the Type of Recurring Payment.

    When completing the accounting lines for line 1 and line 3, select the CAMS Trans Type of Capital Lease. If Type of Recurring Payment was completed first, a blank selection under CAMS Trans Type and Capital Lease Trans Type will be shown. If Type of Recurring Payment was not completed, a listing of all CAMS Trans Types will be shown. The correct selection would Capital Lease. Line number 2 is for interest and the correct CAMS Trans Type would be the blank selection.

  6. CAMS Document

    Upon approval of the purchase order, the CAMS Trans Type of Capital Lease will generate the CAMS document to the initiator of the requisition. The CAMS Document is required to be completed before the leased asset can be created.

    Please reference the EPIC Training Guide for the CAMS Document to find information on how to complete the CAMS document.

  7. Accounting for capital lease agreements

    Accounting for capital lease agreements involves the creation of debt and a corresponding capital asset. The debt and capital asset, in the majority of capital lease agreements, will be created at the total principal amount found on the amortization schedule.

    • Financial document to create the capital lease asset and capital lease debt.

      The Capital Asset Manager in the Capital Asset Office will verify, from the lease documentation received from Purchasing, if a capital asset and debt should be created. Once verified, the asset and debt will be created using the Distribution of Income/Expense (DI) document in KFS. The Capital Asset Manager will create this document for all campuses, other than Indianapolis. The Capital Asset Office at IUPUI will be responsible for the creation of this document on that campus.

      The following example shows the general ledger entries the finished Distribution of Income/Expense (DI) document will post:

      Account Number Object Code DR CR
      66-127-00 7099   $6,501.00
      66-127-00 7019 $6,501.00  

      The debit and credit amount used on the DI is the total principal amount taken from the amortization schedule. These two object codes will generate the following entries to the plant fund account:

      Account Number Object Code DR CR
      95-200-00 9603   $6,501.00
      95-200-00 9899 $6,501.00  
             
      95-200-00 8627 $6,501.00  
      95-200-00 9899   $6,501.00

      The entry to object code 7099 creates the debt and generates an entry to the plant fund account on object code 9603. The 7019 creates the asset and generates an entry to the plant fund account on object code 8627.

      As invoices are paid, a debit to object code 7099 for principal and 4400 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 debt liability. Upon the final payment of a lease, the debt balance will be zero. If the lease payment is $250 and the principal is $180 and interest is $70, the following entry will be made:

      Account Number Object Code DR CR
      66-127-00 7099 $180.00  
      66-127-00 4400 $70.00  
      66-127-00 9041   $180.00
      66-127-00 9041   $70.00
             
      95-200-00 9603 $180.00  
      95-200-00 9899   $180.00

      Monthly, the Capital Asset Manager for the University Capital Asset Office will reconcile each 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.

      At fiscal year-end, all balances of capital lease debt will be reported in the Schedule I-2 For Bonds and Notes Payable.

    • Creation of the capital leased asset.

      Capital leased assets with a unit cost of $5,000 or greater.

      If the lease met GAAP test 1 or 2, the asset will be created using the following objects:

      Description Object Code
      Capital Lease Equipment 7000
      Capital Lease Computer Equipment 7023

      If the lease met GAAP test 3 or 4, the asset will be created using the following object codes:

      Description Object Code
      Capital Lease Equipment 7019
      Capital Lease Computer Equipment 7020

      The asset will be tagged and inventoried.

      The useful life of the asset will be assigned according to the FAS 13 lease criterion that was met.

      If the lease agreement met criterion number 1 or 2, the asset will be depreciated by the university's established useful life.

      If 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 terms of the lease agreement.

      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

      For those leased assets that met criterion number 1 or 2 the asset will remain on the University's books when fully depreciated and the lease liability is paid in full since ownership is present in the lease agreement.

      For those assets that met criterion number 3 or 4, the department is required to determine at the end of the agreement whether or not they will keep or send back the asset since ownership is not indicated in the lease agreement. If the asset is sent back to the vendor an asset retirement document should be issued to retire the asset.
      Capital leased assets with a unit cost of less than $5,000.

      If the unit cost is less than $5,000 an asset will be created using the following object codes:

      Description Object Code
      Capital Lease Equipment 7022
      Capital Lease Computer Equipment 7023

      The asset may be untagged or 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 useful life of the asset will be the terms of the lease agreement. Following is a listing for 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.

  8. Vendor waiving the remaining debt of a capital lease

  9. The department, at times, may work with the vendor to have the remaining debt waived. It is the department's responsibility to report to the Capital Asset Manager that the debt 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 debt will be removed and recorded as a gift. The Capital Asset Manager will issue a GEC to remove the remaining portion of the debt and record gift income. For example: A capital lease with a remaining debt 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 Number Object Code DR CR
    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 debt 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 debt 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.

    For example; A machine was leased for 5 years for $10,000, also depreciating over 5 years. At the end of the third year the remaining debt balance was waived and the asset returned back to the vendor. The net book value of the asset was $4,000 at retirement. The entry posted to the general ledger from the asset retirement and GEC will generate the following entries:

    Asset retirement:

    Account Number Object Code DR CR
    95-200-00 8610   $10,000
    95-200-00 8910 $6,000  
    95-200-00 4998 $4,000  
           
    66-127-00 7099 $4,500  
    66-127-00 4997   $4,500

    The loss to object code 4998 as a result of the asset retirement will net against the entry to 4997 on the income statement.

  10. Lease agreements involving land, land and buildings, real estate and equipment and part of a building.

    At times a lease could be issued for items other than equipment.

    • 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 $4,500 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, 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.

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 transactions 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.
RESPONSIBLE ORGANIZATION: All organizations purchasing items through a lease agreement.