Accounting for Leases

Policy Statement

This policy establishes accounting treatment of lease agreements entered into by the University, both as a lessee and as a lessor.  There are two types of lease classifications: capital and operating.  The proper lease classification is important because it determines the University’s accounting and reporting requirements.  

Reason for Policy

When the risks and rewards of ownership have been passed on to the lessee, generally accepted accounting principles require the lessee to record the lease as an asset.  This policy establishes uniform thresholds and procedures for all parts of the University when recording both operating and capital leases.

Who Must Comply

All Harvard University schools, tubs, local units, Affiliate Institutions, Allied Institutions and University-wide Initiatives must comply.  This policy applies to all new leases entered into as of 7/1/2014; note that addenda to and extensions of existing leases qualify as new leases for purposes of this policy.

Procedures

1.            Understand rules for lease accounting.  Leases that meet certain criteria must be recorded as assets to the lessor; these leases are called capital leases.  Capital leases are recorded on the balance sheet and depreciated over time.  Leases that don’t meet these criteria are called operating leases; operating lease payments are recorded as rental expense.  The criteria that qualify a lease as a capital lease or an operating lease are described below.

2.            Apply lease term threshold. Any item with a lease term of less than 3 years cannot be capitalized.  Treat all leases with terms of less than three years as operating leases.

3.            Apply cash payment thresholds.  Apply the following thresholds when determining when to capitalize an equipment or facility lease.  Note that thresholds should be applied by lease schedule; lease agreements can be for a building, an individual asset, a group of assets, and can fall under the terms of a University-wide master lease agreement.

A.           A lease with annual lease year cash payments greater than $1,000,000 per year or with cumulative spending over the life of the lease greater than $10 million must be capitalized if it meets the criteria outlined in Procedure 4 below.

B.           A lease with annual lease year cash payments between $250,000 and $999,999 that meets the capital lease criteria outlined in Procedure 4 below may be capitalized at the discretion of the tub. 

C.           A lease with annual lease year cash payments below $250,000 must not be capitalized; it must be treated as an operating lease. 

4.            Assess leases that meet cash and term thresholds for capitalization.  An equipment or facilities lease that meets the lease term and cash payment criteria above must be capitalized if it meets any one of the four criteria listed below.  If the lease meets none of these criteria, treat it as an operating lease. 

A.           A lease only needs to meet one of the below criteria in order to be classified as a capital lease.  (See Appendix A for additional guidance.)

a.            Transfer of ownership: Ownership of the asset transfers to the lessee by the end of the lease term.

b.            Bargain purchase option: The lease contains a bargain purchase option (BPO). A bargain purchase option is a lease clause that allows the lessee to obtain title to the leased facilities and/or equipment for less than its fair market value, for example a nominal amount such as $1.

c.            Lease term: The lease term is equal to 75% or more of the estimated economic life of the leased asset at the beginning of the lease term. 

d.            Minimum lease payments: The present value at the beginning of the lease term of the minimum lease payments equals or exceeds 90 percent of the fair value of the leased asset.  This amount excludes the portion of the payments representing executory costs such as insurance, maintenance, and taxes to be paid by the lessor, including any profit thereon.

 

B.           For all leases that tubs intend to capitalize, tubs must send a copy of the lease agreement and support for the capital lease classification to the Associate Director for Accounting Operations in Financial Accounting and Reporting (FAR).  

5.            Record capital leases properly.

A.           Initial setup:  the tub must calculate the amounts and prepare the initial journal entry. However, given the complexity of accounting for capital leases and the fact that it requires central-only object codes, FAR will review the tub’s calculations and upload the journal.  FAR records the entry to establish the capital lease asset and the related liability at the inception of the lease.  The capital lease asset and liability are recorded at an amount equal to either the fair value of the leased property at the lease inception date, or the present value of the lease payments using the incremental borrowing rate, whichever is lower.  (Contact FAR for the current incremental borrowing rate).  This is an important step to ensure all of the University’s financial obligations are consistently valued. The Lease Classification Form (Appendix D) provides guidance on how to calculate the present value of the lease payments.  Tubs should submit this form to FAR along with the journal entry in order to set up the lease. 

B.           Making lease payments: lease payments are the responsibility of the tub.  Ideally, tubs should establish annual purchase orders for their lease obligations.  These payments should follow local payment policies and guidelines for processing and approving payments and are initially coded to expense object codes.

C.           Amortization of the lease liability: The lease liability is reduced throughout the life of the lease using the effective interest method.  On a quarterly basis, tubs are responsible for creating journal entries (for each lease) which reverse the payment coding and reclassify it to the appropriate amortization and interest object codes, as well as reducing the liability.  Each lease payment is allocated between the calculated lease liability amortization and interest expense.  Under this method, interest expense decreases and the liability amortization amount increases over time.  Tubs must send these journal entries to FAR for uploading because they require the use of central-only object codes.  See the example that illustrates the amortization of a lease liability in the “Examples” section of this document.  

D.           Depreciation of the capital lease asset: the depreciation method used depends on which of the four possible capitalization criteria the lease asset meets:

E.            The tub is responsible for the reconciliation of object codes 2793 (Capital Lease Equipment Liability) and 2794 (Capital Lease Building Liability).  If the balances in these accounts are greater than the reconciliation threshold of $1M, the quarterly reconciliations should be kept on file in accordance with the quarterly financial close checklist. 

6.            Special treatment for leases involving land and land with buildings. 

A.           Leases involving land only: If a lease involves land alone, use only capitalization criteria 1 and 2 to determine the proper classification of the lease.  If the lease meets either of these criteria, classify the land as a capital lease and follow the capital lease accounting procedures, with the exception that the land is not amortized.  If the lease meets neither criteria 1 nor 2, account for it as an operating lease.

B.           Leases involving land and building(s): When the lease involves land and buildings, tubs must first calculate each asset’s relative fair value (i.e., using recent sales, appraisals or tax statements) and then answer a series of questions to determine the proper treatment.  See Appendix B for a decision tree. 

7.            Record operating leases properly.  An operating lease is treated as a true rental of property, which is not recorded on the balance sheet, but as an expense.

A.           Actual vs. straight-line: operating leases must be recorded on a straight line basis even if the payments vary in amount over the lease term,  if the impact of the deferral equals the following annual thresholds. Include in rent expense the basic rent amounts plus any other payments required under the lease terms (e.g., a lease non-renewal penalty or other likely payment required by the lessee).  For operating leases with straight-line impact under these thresholds, rent expense recorded may equal the actual amounts paid. 

a.            Large schools: $500,000 or more annual impact

b.            Small schools: $250,000 or more annual impact

B.           Escalating rent payments:  lease payments that are not of equal amounts but that escalate during the life of the lease should be recognized on a straight line basis, unless another systematic and rational basis is more representative of the time pattern in which the leased property is physically employed.   As such, the time value of money and anticipated inflation should not be considered in allocating scheduled rent increases

C.           Rent expense adjustments:  If the actual rent expense is higher or lower than the straight-line basis rent expense, the tub must record adjusting entries for the difference.  See Example #3 in Appendix C for an example of the accounting. 

D.           Initial direct costs incurred by the lessee: any initial direct costs related to the lease are expensed as incurred (e.g., commissions, legal fees, costs of preparing documents, etc.).

8.            Account for all leases timely.

A.           Capital leases: the accounting for capital leases should be recorded at the lease inception date and must be recorded no later than quarter end.  FAR makes adjustments to plant and equipment equity concurrently with the periodic lease payments.

B.           Operating leases: the lessee records rent expense as payments are made according to the lease specifications.  If payments vary over the course of the lease and meet the thresholds outlined in Procedure 7 above, tubs must record an adjustment to properly record the rental expense on a straight-line basis no later than quarter end.

9.            Treat intertub leasing properly.  When assets are leased between tubs, they may only be accounted for as operating leases, and no gain or sale may be recognized on the transaction.  Consult the University’s Internal Billing Transactions Policy and Internal Transfer Policy for the appropriate accounting treatment.

10.         Account for leasehold improvements:

Capital projects involving externally leased property (or leased property between two tubs) should be treated as leasehold improvements and recorded as a “Capital Leasehold Improvement” on the lessee’s balance sheet because leasehold improvements result in a true asset addition.  The leasehold improvement should be recorded and amortized over the shorter of the useful life or the lease term. 

11.         Account for executory costs correctly: Executory costs include utilities, repairs, maintenance, insurance, common area expenses, and taxes paid for the leased asset during its economic life.  They are considered period costs and therefore must be expensed as incurred.  These expenditures may be the responsibility of either the lessee or lessor, depending on the lease terms. 

12.         Maintain supporting documentation.  For any lease that has been capitalized or operating lease greater than the threshold, keep the following documentation on file for the life of the leased asset plus an additional seven years:

A.           The master lease agreement

B.           A copy of the completed “Lease Classification Form”

C.           Supporting documentation for any additional assumptions used in determining whether the lease is capital or operating

D.           For capital leases, tubs must also maintain a schedule of payments showing amortization of the lease-related liability.

13.         Make required disclosures for year-end lease reporting: the University is required to disclose the total gross assets under capital leases as well as both capital and operating lease commitments for each of the next five years and thereafter in its annual financial report.  FAR coordinates the process of obtaining this information from the tubs each fiscal year-end using a reporting materiality threshold of $500,000 per lease.

14.         Account for leases where Harvard is the lessor. Accounting for leases where Harvard is the lessor follows the same rules outlined above, except that Harvard is on the other side of the transactions.  If you have questions about this accounting, please contact Financial Accounting and Reporting.

Responsibilities and Contacts

School/tub finance offices are responsible for ensuring that local units abide by this policy and the accompanying procedures. Tubs must notify FAR of capital leases as they arise throughout the year and no later than quarter end and must disclose capital and operating lease commitments as part of the year-end financial reporting process.  Schools and Tubs are responsible for making all payments and journal entries.  Tubs are also responsible for processing journal entries to adjust operating lease payments to a straight line basis where required.

Financial Accounting and Reporting (FAR) maintains this policy and provides guidance regarding the policy. With information supplied by the tubs, FAR is responsible for recording the initial setup of the capital lease asset and liabilities, for amortizing the lease liability, and for recording depreciation of the capital lease asset.  At year end, FAR collects information from tubs regarding all lease commitments (both operating and capital) and supplies this information to external auditors. Contact: Associate Director for Accounting Operations at (617) 495-3766

Office for Sponsored Programs (OSP) advises units on compliance with the terms of federal and nonfederal awards.  Contact OSP with questions regarding sponsored compliance on leases charged on awards.  Contact: Manager of Reporting, Cost Analysis and Compliance at (617) 496-4771

Definitions

Capital lease: a lease considered to have the economic characteristics of asset ownership. A capital lease is treated as a purchased asset for accounting purposes, meaning it is recorded as an asset on the balance sheet and depreciated over time.

Bargain purchase option (BPO): A bargain purchase option is a lease clause that allows the lessee to obtain title to the leased facilities and/or equipment for less than its fair market value, for example a nominal amount such as $1.

Effective interest rate: the interest rate on a loan or financial product restated from the nominal interest rate as an interest rate with annual compound interest payable in arrears.  It is used to compare the annual interest between loans with different compounding terms (daily, monthly, annually, or other).

Executory cost: costs of an ongoing lease agreement. Executory costs include utilities, repairs, maintenance, insurance, common area expenses, and taxes paid for the leased asset during its economic life.  They are considered period costs and therefore must be expensed as incurred.  

Fair market value: Probable price at which a willing buyer will buy from a willing seller when (1) both are unrelated, (2) know the relevant facts, (3) neither is under any compulsion to buy or sell, and (4) all rights and benefit inherent in (or attributable to) the item must have been included in the transfer.

Incremental borrowing rate: Interest rate a lessee would have to pay if, instead of leasing, he or she finances the purchase of the same asset.

Large schools: for purposes of this policy, FAS, HMS, HBS

Lease bonus: An amount paid by a lessee to a lessor as consideration for granting a lease, usually as a lump sum; this payment is in addition to any rental or royalty payments.

New leases: for purposes of this policy, new leases are leases entered into after 7/1/2014, including addenda to or extensions of existing leases.

Operating lease: a lease treated as a true rental for accounting purposes.  Operating lease payments are recorded as rental expense.

Small schools: for purposes of this policy, all other schools and units other than FAS, HMS, HBS

Related Resources

Facilities and Equipment Accounting policy: http://policies.fad.harvard.edu/pages/facilities-and-equipment

Internal Billing Transactions Policy: http://policies.fad.harvard.edu/pages/internal-billing-transactions

Internal Transfers Policy: http://policies.fad.harvard.edu/pages/internal-transfers

Revision History

N/A

Appendices

Appendix A: Decision Tree for Classifying Operating vs. Capital Leases

Appendix B: Decision Tree for Treatment of Leases Involving Land and Buildings

Appendix C: Examples of Proper Accounting for Leases

Appendix D: Lease Classification Form

See also: Policy, Accounting