PACE - Financial Policies - Leases

LEASE ACCOUNTING

  1. PURPOSE - Cities use a variety of leasing arrangements to stabilize cash flows and reduce risk and uncertainty. The purpose of this policy is to provide guidelines and procedures to ensure compliance with generally accepted accounting principles and all other state and federal requirements surrounding leases (whether the City is lessee or lessor).  Procedures aim to provide all pertinent information and decision-making input to the finance department so that accounting and reporting may be accomplished according to applicable governmental accounting standards.
  2. SCOPE - The following guidelines apply to operating leases of equipment, buildings, land, or any other tangible physical property which the City leases to, or leases from, a third party. Government Accounting Standards Board Statement No. 87 requires accounting for and reporting lease activity on the City’s statement of net position beginning January 1, 2022. 
  3. POLICY - This policy establishes the accounting treatment of lease agreements and agreements that contain lease components entered into by the City, both as a lessee and as a lessor. The lessee is the party granted use rights of an asset as part of an agreement. The lessor is the owner of the assets identified in the agreement. There are two types of lease classifications for a lessee: capital and operating. There are three types of leases for a lessor: direct financing, sales-type, and operating leases. The proper lease classification is important because it determines the accounting and reporting requirements. A lease exists when there is a contract, or part of a contract, which conveys the right to control the use of an asset for a period of time in exchange for consideration (i.e., payment). The lessee is determined to have control of the use of an asset if it has the ability to determine how the asset is used and the right to substantially all the economic benefits arising from the asset.
  4. PRACTICE
  • Lease Approvals and Responsibility for Reporting

All new lease agreements or lease term extensions shall be reviewed by the City Administrator and Finance before approval. It is the responsibility of Finance to prepare journal entries to record leases in accordance with accounting standards. It is the responsibility of City departments to provide required disclosure information to Finance for financial statement note disclosure purposes in accordance with accounting standards. When uncertainty exists as to required lease information or required disclosures, it is the responsibility of City staff to consult with Finance for guidance.

  • Lease Criteria

​​​​​​​When possible, the applicable interest rate should be stated in the lease contract. The contract should clearly state the initial term, extensions, and cancellation clauses.

To determine the term of the lease at inception for accounting purposes, Finance will make a judgement of whether the total term of the lease should include options to extend(extensions are more likely than not to be exercised by the City or the counterparty). This assessment shall be documented in writing or electronically. Factors to consider in the likeliness of exercising lease extensions are:

  1. City specific (degree of changing needs, prior pattern of execution of extensions)
  2. Market based (competitive pricing, budget, and economy)
  3. Contract based (economic incentives or penalties)
  4. Underlying asset (obsolescence, aging of asset, new features available)

When a service component is part of a lease contract, the vendor shall provide the portion of lease payment that pertains to services.

  • Lease Extensions

For leases with extension provisions, the decision authority to extend or terminate each lease will rest with the Department Director, City Administrator, and Finance Director.

  • Procurement Standards

​​​​​​​Finance will ensure each lease complies with procurement standards subject to state law and federal uniform grant guidance, if applicable.

  • Capitalization Threshold

Leases which do not meet the capitalization thresholds are not subject to this policy, except as required by state law or federal grant uniform guidance. Finance has the authority to exercise judgment on materiality of lease liabilities to the financial statements. The lease liability materiality threshold will be 10% of total noncurrent liabilities. The dollar amount of the threshold for lease liabilities should be reevaluated each year, as any changes in debt or other payables would affect the materiality of lease liabilities. The capitalization threshold for lease assets will be equal to the threshold for capital assets.

  • Discount Rate

Future lease payments will be discounted to present value at the date of inception to arrive at the recorded at the lease liability and/or lease asset. The following interest rates shall be used for discounting, in order of validity:

  1. For the City as lessee:
    • The interest rate state in the lease contract; or
    • The lessee’s incremental borrowing rate (the rate of interest that would be charged to borrow the amount of lease payments during the lease term). This rate could be obtained by referencing other recent debt of the City on similar assets of by obtaining quotes from a financial institution.
  2. For the City as lessor:
    • The rate implicit in the lease, if determinable;
    • The lessee’s estimated incremental borrowing rate or published market rates; or
    • The City’s own incremental borrowing rate, obtained from quotes from financial institutions or from City debt issues to purchase comparable assets.
  • Lease Asset and Liability Review

Each year, the Finance Department will review each lease asset and liability for impairment or a required remeasure.

Impairment: A lease asset will be considered impaired when the utility of that asset no longer meets the function originally intended at the inception of the lease. An impairment must be recorded in the period recognized if the magnitude of the decline in utility is significant and the decline is unexpected. Examples of impairment of a lease asset are:

  1. Physical damage
  2. Change in laws or regulations affecting the use of the asset
  3. Obsolescence
  4. Change in expected duration of use
  5. Construction stoppage

Remeasure: A lessee should remeasure the lease liability and update the discount rate if any of the following have occurred:

  1. Change in lease term
  2. Contingent payment conditions change
  3. Probability of a purchase option changes from reasonably certain to not reasonably certain, or vice versa.

 

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