Business Procedures Manual

Essential business procedural components for University System of Georgia institutions.

7.11 Leased Assets

7.11.1 Leased Land, Buildings, Equipment and Other Assets

(Last Modified on May 1, 2017)

A lease agreement is considered a capital lease agreement when substantially all of the risks and/or rewards of ownership are assumed by the lessee. Land, buildings, equipment and/or other assets under capital lease, which meet or exceed established capitalization thresholds, should be capitalized if the lease agreement meets any one of the following criteria:

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

  2. The lease contains a bargain purchase price. A bargain purchase option gives the lessee the opportunity to acquire the property at the end of the lease for a very favorable price.

  3. The lease term is equal to 75 percent or more of the estimated economic life of the leased property.

    Note: Leases with annually renewable lease terms, in which the likelihood of non-renewal is remote, should be considered long-term leases for purposes of evaluating this criterion. Adequate documentation must be maintained to justify treatment of leased assets.

  4. 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.

Leases that do not meet any of the above requirements should be recorded as operating leases and reported in the notes to the financial statements.


7.11.2 Calculation of Leased Asset and Liability Amounts

(Last Modified on May 4, 2017)

The lessee treats the capital lease as if an asset were being purchased over time. It is essentially a financing transaction whereby the asset is acquired and a corresponding obligation (liability) is created.

The asset and liability should be recorded at the lower (lesser) of:

  • Fair market value of the asset at the inception of the lease, or
  • “Cost” = present value of the minimum lease payments, using the lessee’s incremental borrowing rate as the interest rate. If lessor’s implicit interest rate in the lease is less than the lessee’s incremental borrowing rate and is known by the lessee, the lessee must use the lessor’s implicit rate. The lessor’s implicit interest rate is considered more accurate because it is effectively the discount rate that applies to difference between total minimum lease payments and fair value of the leased property.

Note: Generally, “cost” should be the basis we use, because it is unlikely that fair market value would be less than cost basis. If fair market value is determined to be the lower number, please contact the System Office before making entries.

In an effort to be consistent in accounting for PPV constructed capital leased assets and to match lease liability amounts to the lease receivable amounts reported by lessors, it has been determined that actual project costs should be used as the “cost” basis. Actual project costs will consist of construction/purchase costs plus capitalized interest paid during the construction period. These amounts should be obtained from the lessor/foundation.

Some capital lease obligations have executory costs built into the total lease payment. These are costs such as insurance, maintenance and taxes. If such costs are part of the periodic lease payments, they should be shown separately on the schedule of future lease payments as a reduction from the total minimum lease payments to get to the net lease liability outstanding. If the lessee pays these costs directly, they would be reported as part of normal operating expenses of the institution and there would be no adjustment to the scheduled lease payments.

Example 1: Recording a Capital Lease with a Third Party – Lessee’s Books

The University leases a copier from an office equipment retailer for three years. The lease term begins July 1, 20XX at an annual rental of $3,000 with a down payment of $500 due on the first day of the lease. At the end of the lease term, the University may purchase the copier for $1. The asset has a useful life of 5 years. If the University had purchased this copier outright, the cost would have been $8,500. The incremental borrowing rate of the University is unknown. In addition, the lessor’s implicit interest rate is not stated.

Step 1: Does the lease meet the criteria for capitalization?

  • Ownership Transfer: – No
  • Written Bargain: – Yes
  • 75% life: – No (3 years/5 years = 60%)
  • 90% of FMV: – Maybe, but it is not necessary to calculate because one of the four criteria has already been met.

Step 2: Determine the cost of the asset to be recorded. If the cost of the asset is provided by the lessor, use that number as the cost basis. If not, compute the present value of the minimum lease payments, excluding executory costs.

In this example, since the lease is with a third party and the cost of the asset was known to be $8,500, the present value of the minimum lease payments can be presumed to be $8,500. Since this example included a $500 down payment, the debt amortization schedule will be based on a debt amount of $ 8,000 for 3 years. Generally, the lessor should be able to provide an amortization schedule including principal and interest payments. However, if for some reason, amortization schedules are not available from the lessor, the institution/lessee will need to create amortization schedules using the Internal Rate of Return (IRR) function available from Excel. In this example, since the debt amount is known to be $ 8,000 and total payments on the lease are $ 9,000, by using the IRR function an interest rate implicit to the lease of 6.13% is calculated.

Step 3: Record the leased asset at the lesser of the asset’s fair market value at the inception or the present value of the minimum lease payments. In this example, since the present value of the minimum lease payments (cost) is determined to be the same as the fair market value, capitalize the asset and lease liability at $8,500.

JOURNAL ENTRIES

  • To record the lease on the books at July 1, 20XX. Since a cash down payment is required, the Actuals Ledger will be used to record that payment, with the Capital Ledger recording the asset and liability.
    ACTUALS LEDGER
    DR 818100 Lease Purchase-Principal $500
    CR Cash $ 500


    CAPITAL LEDGER
    DR 165100 Leased Equipment $ 8,500
    CR 219400 Lease Purchase Obligations-Current $8,500 (*)
    (*) Since the lease liability automatically posts to Lease Obligations-Current Year, Year-end journal entry # 18 (b) is available to correctly break out current vs long-term portions of lease obligation.


  • To record the first year’s payment due on June 30, 20XX in Actuals Ledger. Also record depreciation expense and reduction of principal paid in Capitals Ledger.
    ACTUALS LEDGER
    DR 818200 Lease Purchase: Interest expense ($8,000 x 6.13%) $ 490
    DR 818100 Lease Purchase-Principal ($3,000 - $490.40) $2,510
    CR Cash $3,000

    CAPITALS LEDGER
    DR 890100 Depreciation expense ($8,500/5) (*) $1,700
    CR 165190 Accumulated depreciation-Leased Equipment $1,700
    DR 219400 Lease Purchase Obligation-Current $2510
    CR 818100 Lease Purchase - Principal $2510
    (*) The asset is depreciated over the assets useful life of 5 years and not the lease term, which is only 3 years.


Example 2: Recording a Capital Lease with a Related Party when a Ground Lease is in Effect – Lessee’s Books

University Foundation(lessor) leases a building to the University (lessee) for an initial term of one year plus twenty-two renewable one-year terms (total 23 years) beginning July 1, 20XX at an annual rental of $ 883,531 per year. The building asset has a thirty-year useful life according to BPM useful life guidelines. There is a special stipulation in the lease that states that the building and contents will be gifted to the University when all of the lease payments have been made, unless the University executes the terms of the ground lease. The first payment is due at the end of the first year and each subsequent year. As noted earlier, the cost basis for assets leased under the PPV program will be the construction costs paid from the Project Cost Fund plus capitalized interest paid during the construction period. This information is available from the lessor. If there are any unspent proceeds remaining in the Project Cost Fund at time asset is turned over to institution per the Certificate of Occupancy, the foundation should record an Accounts Payable for the unspent proceeds remaining. By making this entry, all Project Cost Funds, along with capitalized interest, will be included in the cost basis of the asset transferred to the University. There are no executory costs associated with this lease, and the University’s incremental borrowing rate is unknown. For this example, Project Cost funds spent were $11,700,000, unspent funds remaining in Project Cost Fund at time of transfer were $ 500,000 and capitalized interest paid during construction period was $ 300,000 for a total project cost of $ 12,500,000.

The University owns the land upon which the leased improvements were constructed and leases the land to the University Foundation for a lease term that ends on the same date as the building lease. At the end of the ground lease term, all improvements title to the University. Within the ground lease, there is language giving the University the option to require the University Foundation to remove all improvements at the Foundation’s expense.

The University Foundation provided an amortization schedule for principal and interest using an interest rate of 4.5%.

Step 1: Does the lease meet the criteria for capitalization?

  • Ownership Transfer: Yes, but not applicable. Due to the language in the Ground Lease, there may be no capital asset at the end of the lease term if the University exercises its option to have the building removed by the Foundation, making this criterion not applicable.
  • Written Bargain:No
  • 75% life: Yes (23 years/30 years = 76.7%)
  • 90% of FMV:Yes ($12,500,000 x 90% = $11,250,000<$12,500,000PV)

Step 2: Record the leased asset at the lesser of the assets’ fair market value at the inception of the lease or the present value of the minimum lease payments. Since the cost is known to be $12,500,000, the present value of the minimum lease payments is essentially the same as the fair market value, thus the leased asset and lease liability will be recorded at $ 12,500,000.

JOURNAL ENTRIES

  • To record the lease on the books at July 1, 20XX. Since no cash down payment involved, addition to AM module will update Capital Ledger only.
    CAPITAL LEDGER
    DR 162100 Leased Building and Building Improvements $12,500,000
    CR 219400 Lease Purchase Obligations-Current $12,500,000 (*)
    (*) Since the lease liability automatically posts to Lease Obligations-Current Year, Year-end journal entry # 18 (b) is available to correctly break out current vs long-term portions of lease obligation.
  • To record the first payment due on June 30, 20xx in Actuals Ledger. In addition, depreciation expense and reduction in lease obligation will be recorded in Capital Ledger.
    ACTUALS LEDGER
    DR 818200 Lease Purchase: Interest expense ($12,500,000 x 4.5%) $562,500 (*)
    DR 818100 Lease Purchase-Principal $321,031
    CR Cash $ 883,531
    (*) Interest will normally be calculated monthly or semi-annually, which would yield different results than this sample, which used an annual interest calculation for example purposes only.
    CAPITAL LEDGER
    DR 890100 Depreciation expense (12,500,000/23 years) $ 543,478 (*)
    CR 162190 Accumulated Depreciation-Leased Building $543,478
    DR 219400 Lease Purchase Obligation-Current $321,031
    CR 818100 Lease Purchase - Principal $321,031
    (*) Since the University has executed a ground lease with the lessor, which gives the University the option to require that the building demolished at the end of the lease term, it is appropriate to depreciate the building over the shorter life of the lease (23 years) as opposed to the normal depreciable life as set by BPM standards (30 years). In addition, no residual value was applied to this asset because of the ground lease.


Example 3: Recording a Capital Lease with a Related Party when no Ground Lease is in Effect – Lessee’s Books

The circumstances here are the same as in Example 2, except that in this scenario, the asset is built on foundation property and there is no need for any ground lease between the University and the University Foundation. The land has a value of $ 500,000. Total base rent/lease liability payments are $ 918,872 yearly. In addition, additional rent of $ 300,000 per year is paid by University into Renewals and Replacement Reserve held by Trustee. The $ 300,000 is considered executory costs.

Step 1: Does the lease meet the criteria for capitalization?

  • Ownership Transfer: Yes
  • Written Bargain: No
  • 75% life: Yes(23 years/30 years = 76.7%)
  • 90% of FMV: Yes ($13,000,000 x 90% = $11,250,000<$ 13,000,000 PV)

Step 2: Record the leased asset at the lesser of the assets’ fair market value at the inception of the lease or the present value of the minimum lease payments. Since the cost is known to be $12,500,000 for the building and $ 500,000 for the land, the present value of the minimum lease payments is essentially the same as the fair market value, thus the leased asset and lease liability will be recorded at $ 13,000,000.

JOURNAL ENTRIES

To record the lease on the books at July 1, 20XX. Only the Capitals ledger is effected since no down payment involved. The land value and building value must be separated when recording the transaction.

    CAPITALS LEDGER
    DR 161100 Leased Land and Land Improvements $ 500,000
    DR 162100 Leased Building and Building Improvements $12,500,000
    CR 219400 Lease Purchase Obligations-Current $ 13,000,000 (*)
(*) Since the lease liability automatically posts to Lease Obligations-Current Year, Year-end journal entry # 18 (b) is available to correctly break out current vs long-term portions of lease obligation.

To record the first payment due on June 30, 20XX in the Actuals Ledger. Also, the additional rent payment is recorded in Actuals Ledger. Depreciation expense and reduction in lease obligation will be recorded in Capital Ledger.

    ACTUALS LEDGER
    DR 818200 Lease Purchase: Interest expense ($ 13,000,000 x 4.5%) $ 585,000
    DR 818100 Lease Purchase-Principal $ 333,872
    CR Cash $ 918,872
    DR 719100 Rents $ 300,000
    CR Cash $ 300,000
Note: The additional rents portion of the lease payment that is sent to the Trustee to be held for repairs and renovations of the leased property under the PPV program should be included as part of executory costs.

    CAPITAL LEDGER
    DR 890100 Depreciation expense ($12,500,000 x 90%)/30 years) $375,000
    CR 162190 Accumulated Depreciation-Leased Building $ 375,000
    DR 219400 Lease Purchase Obligation-Current $333,872
    CR 818100 Lease Purchase - Principal $338,872
Note: Leased Land should not be depreciated. Also, residual values are currently calculated as assets are added to the Asset Management Module as long a proper asset profiles are used.

Lessor accounting treatment follows the same rules as Lessee. From Examples 2 and 3, the University Foundation should also treat the lease as a capital lease and record a Lease Receivable. The Lease Receivable recorded by the University Foundation should agree with Lease Purchase Obligation reported by the University. Universities must work with their Foundations to ensure consistent lease treatment.

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