T/TAS has recently assisted a program with a facilities question which may become more common. “When does a facility lease become a capital lease instead of an operating lease?” Before we go down that path, a better question is, “What is the implication of the differences?”

Well to keep it quick, capital leases had to have had prior approval before entering into them and operating leases don’t. This means if we have a lease that turns out to be a capital lease, we were expected to seek prior approval, and if we did not then we may have a non-compliance. Incidentally, the non-compliance does not have to be found in a tri-annual review, but that is a different story. In a world where we are all seeking to stay away from non-compliances, please review your leases and use the following information.

For lessees, a lease is a financing transaction called a capital lease if it meets any one of four specified criteria listed below; if not, it is an operating lease. Capital leases are treated as the acquisition of assets and the incurrence of obligations by the lessee. As such, prior approval must be sought. Operating leases are treated as current operating expenses.

If the following four criteria are met, the lease shall be classified as a capital lease by the lessee (criteria from FASB 13, http://www.fasb.org/pdf/fas13.pdf‎). Otherwise, it shall be classified as an operating lease:

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

b. The lease contains a bargain purchase option.

c. The lease term is equal to 75 percent or more of the estimated economic life of the leased property (as defined in paragraph 5(g)). However, if the beginning of the lease term falls within the last 25 percent of the total estimated economic life of the leased property, including earlier years of use, this criterion shall not be used for purposes of classifying the lease.

d. The present value at the beginning of the lease term of the minimum lease payments, excluding that portion of the payments representing executory costs such as insurance, maintenance, and taxes to be paid by the lessor, including any profit thereon, equals or exceeds 90 percent of the excess of the fair value of the leased property to the lessor at the inception of the lease over any related investment tax credit retained by the lessor and expected to be realized by him. However, if the beginning of the lease term falls within the last 25 percent of the total estimated economic life of the leased property, including earlier years of use, this criterion shall not be used for purposes of classifying the lease. A lessor shall compute the present value of the minimum lease payments using the interest rate implicit in the lease. A lessee shall compute the present value of the minimum lease payments using his incremental borrowing rate, unless (i) it is practicable for him to learn the implicit rate computed by the lessor and (ii) the implicit rate computed by the lessor is less than the lessee's incremental borrowing rate. If both of those conditions are met, the lessee shall use the implicit rate.

So if our lease has possible extensions built into it that define our potential occupancy to more than 22.5 years we may have a capital lease. We may also have a capital lease if the value of our lease payments equals or exceeds 90% present value at the beginning of the lease term of the minimum lease payments, excluding that portion of the payments representing executory costs such as insurance, maintenance, and taxes to be paid by the lessor, including any profit thereon, equals or exceeds 90 percent of the excess of the fair value of the leased property to the lessor at the inception of the lease over any related investment tax credit retained by the lessor and expected to be realized by him. So we are told to compute the present value of the minimum lease payments using his incremental borrowing rate.

These are two items that could get agencies into difficulty, so please check these items. If you have any questions please do not hesitate to contact Perry Davis or J. Christopher Watkins by email or by phone at 800-882-7482 for more information.