Accounting for Capital Leases, Works of Art, Infrastructure Assets

In this article we will discuss about:- 1. Accounting for Capital Leases 2. Accounting for Works of Art and Historical Treasures 3. Accounting for Infrastructure Assets and Depreciation 4. The Primary Government and Component Units.

Accounting for Capital Leases:

The notes to the 2006 financial statements of the City of Cleveland, Ohio, describe its role as a lessee:

The City has entered into agreements to lease equipment. Such agreements are treated as lease purchases (capital leases) and are classified as long-term lease obligations in the financial state­ments. The lease contracts contain annual one-year renewal options that can be exercised by the City if sufficient funds are appropriated by City Council. Upon the exercise of each annual one- year renewal option and satisfaction of the lease obligations related thereto, title to the equip­ment will pass to the City.

In April 2003, the City entered into an equipment lease agreement with Banc of America Leasing & Capital. As a result of this transaction, the City purchased approximately $6,105,000 of heavy-duty vehicles and apparatus for the Departments of Public Safety, Public Service and Parks, Recreation and Properties and will make lease payments from its Restricted Income Tax for a period of seven years.

In contrast, the notes to the 2006 financial statements of the City of Birmingham, Alabama, describe that city as a lessor:

The City entered into a Lease, Assignment, and Operating Agreement with the Birmingham Airport Authority. Under the lease portion of the agreement, the Authority leased the entire airport facility and operation with net assets of $16,490,000 for a term of fifty years begin­ning September 16, 1986. The lease, which has been properly recognized as a direct financ­ing lease, has been recorded in the General Fund financial statements at the minimum lease payments.

Obviously, state and local governments (in the same manner as a for-profit business) sometimes lease property rather than purchasing it directly. Leasing can provide lower interest rates or reduce the risk of obsolescence and damage. Leasing is simply an efficient way that many organizations (for-profit or governmental) can acquire needed equipment, machinery, build­ings, or other assets. At the same time, like the City of Birmingham, a government can find itself in the position of lessor. This is particularly true when the city or state holds property that it prefers not to operate itself.

For reporting purposes, such leases must be recorded as either capital leases or operating leases. The initial accounting issue is to separate one type from another. In that regard, the GASB has accepted the criteria applied in FASB SFAS13, “Accounting for Leases,” as the method of differentiation.

SFAS 13 established four criteria; a lease that meets any one of these is held to be a capital lease:

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

2. The lease contains an option to purchase the leased property at a bargain price.

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

4. The present value of rental or other minimum lease payments equals or exceeds 90 percent of the fair value of the leased property.

Thus, for example, assume that a city leases a truck that has a 10-year life and a fair value of $50,000. In each of these four sample situations, the city is required to account for the prop­erty as a capital lease:

i. The lease is for six years, but the city automatically receives title to the truck at the end of that term (so that criterion 1 is met).

ii. The lease is for five years, but the city can buy the truck for $3,000 at the end of that time, an amount that is viewed as significantly less than the expected fair value at that point (so that criterion 2 is met).

iii. The lease is for eight years, after which the truck will be returned to the lessor (so that criterion 3 is met).

iv. The lease is for seven years, but the present value of the minimum lease payments is equal to or more than $45,000, or 90 percent of the fair value (so that criterion 4 is met). In this last example, the lessee is viewed as paying the equivalent of the purchase price to obtain use of the asset.

Government-Wide Financial Statements:

In reporting property obtained by capital lease, accounting used for the government-wide financial statements is the same as for a for-profit enterprise. The government-wide financial statements report both an asset and a liability, initially at the present value of the minimum lease payments, in the same manner as the accounting for a debt-financed acquisition.

Assume, for example, that a police department signs an 8-year lease for a truck with a 10-year life. Because this contract meets the third of the preceding criteria, this transaction must be recorded as a capital lease. Assume also that the lease calls for annual payments of $10,000 per year with the first payment made at the signing of the lease and that a 10 percent annual interest rate is appropriate for the city.

The present value of the minimum lease payments applying a 10 percent annual interest rate to an annuity due for eight years is $58,680 (rounded). The city makes the following entries within the governmental activities because the lease relates to the police department. However, the same reporting is appropriate within the business-type activities if an enterprise fund had been involved. No accounting distinction between the two types of activities is drawn.

Government-Wide Financial Statements:

Assuming that the straight-line method is being used the city should recognize deprecia­tion expense of $7,335 ($58,680/8 years) at the end of this first year. However, if the title to the asset will be transferred to the city or if a bargain purchase option exists, the full 10-year life is appropriate for depreciation purposes because the lessee (the city) will expect to get full use of the asset.

At the end of the first year, when the city makes the next payment, part of that $10.000 will be attributed to interest with the remainder viewed as a reduction in the liability principal. Because the first payment has reduced the obligation to $48.680 and the interest rate is 10 per­cent, the interest recorded for the first year is $4,868. The remaining $5,132 ($10.000 less $4,868) decreases the debt to $43,548.

Government-Wide Financial Statements:

Fund-Based Financial Statements:

Assume that the same lease is being recorded in the fund-based financial statements for the governmental funds. If a proprietary fund is involved, the handling is the same as in the pre­ceding situation. A difference appears only for the governmental funds.

Using the same eight-year lease in connection with the truck being obtained and payments of $10,000 per year, an amount with a present value of $58,680, the General Fund (or whichever governmental fund is gaining use of the asset) records the following entry:

Fund-Based Financial Statements:

Note that the General Fund reports neither the capital asset nor the long-term liability because they are neither current financial resources nor claims to current financial resources. At the end of this initial year, when the next payment is made, $4,868 (10 percent of the oblig­ation after the first payment) is considered interest; the rest reduces the principal.

Fund-Based Financial Statements:

At first glance, the fund-based journal entries appear to be double counting the expendi­tures, once when the asset is obtained and again when the periodic payments are made. This approach, though, is appropriate. The government had an option; it could have either leased the asset or borrowed money and bought the asset. Because the overall result is the same in both cases, the reporting should not create different pictures.

The preceding entries seek to mirror the presentation that would have resulted in fund- based statements if the city had followed the alternative strategy for acquiring the asset:

(1) Borrowed money on a long-term liability,

(2) Used the money to acquire the asset, and

(3) Subsequently paid the long-term liability and any accrued interest.

If the city had used this borrow-and-buy approach, the recording would have been as follows in the fund-based statements:

1. To reflect the borrowing, the city would have reported another financing source because the money received did not come from a revenue.

2. At the time of the asset’s acquisition, the city would have shown an expenditure in keeping with the goal of presenting the changes in current financial resources.

3. For the same reason, the subsequent payment of debt and interest would have led to a sec­ond recording of expenditures.

Consequently, if the city had borrowed money and bought the asset, one “other financing source” and two separate “expenditures” would result. The preceding journal entries created for the capital lease are structured to arrive at that same reporting impact.

The radical differences between fund-based financial statements and government-wide financial statements are, once again, quite striking.

At the end of this first year, the resulting figures in the two statements are not comparable in any way:

Accounting for Works of Art and Historical Treasures:

Private not-for-profit organizations have long debated the proper reporting of artworks and other museum pieces they buy or receive by gift. Governmental accounting occasionally faces the same issue. How should a government report works of art museum artifacts, and other historical treasures in its financial statements?

Assume, for example, that a city maintains a small museum in the basement of its main office building. The museum was created to display documents, maps, and paintings that depict the history of the city and the surrounding area. The government bought several of these items, but local citizens donated a number of them. Several of these purchased and donated pieces are quite valuable.

GASB Statement 34 is clear on the handling of the items acquired for this city museum. It states that, except in certain specified cases, “governments should capitalize works of art, historical treasures, and similar assets at their historical cost or fair value at date of donation.” Thus, the government-wide statement of net assets should report an antique map bought for $5.000 as an asset at that cost. In the same manner, a similar map received as a gift is also recorded as a $5,000 asset.

If the city bought the map for cash, the journal entry is-

Government-Hide Financial Statements:

Because the city paid cash for the map, a decrease occurs in current financial resources so that the following entry is recorded in the fund-based financial statements even if the museum is accounted for within the General Fund.

However, if the museum has a user charge so that it is reported as an enterprise fund the preceding entry is replicated to account for the acquisi­tion in this proprietary fund:

Fund-Based Financial Statements:

Conversely, if this map had been donated to the city, capitalization of the asset for government- wide financial statements is still mandated based on its fair value at the date of conveyance. The gift is viewed as a voluntary non-exchange transaction so that a revenue will be properly recog­nized when any eligibility requirements have been met.

The following entry is appropriate as soon as all eligibility requirements are satisfied but, until then, the credit should be a deferred revenue. No parallel entry is made in the fund-based financial statements for the governmental funds because no change occurs in the amount of available current financial resources.

Government-Wide Financial Statements:

A theoretical problem arises in the recognition of such assets in government-wide financial statements regardless of whether they were purchased or obtained by gift. Unless a user charge is assessed, a map displayed for the public to see does not generate cash flows or any other direct economic benefit. Therefore, does the map actually qualify as an asset to be reported?

The GASB “encouraged” the capitalization of all such artworks and historical treasures.

However, if the following three criteria are met, recording such an item as an asset is optional:

1. It is held for public exhibition, education, or research in furtherance of public service rather than financial gain.

2. It is protected, kept unencumbered, cared for, and preserved.

3. It is subject to an organizational policy that requires the proceeds from sales of collection items to be used to acquire other items for collections.

If these guidelines are all met, the artwork or historical treasure does have value, but it will not provide any direct economic benefit to the government. Thus, although the donation must be recorded, it does not have to be classified as an asset. Instead, in the entries shown for the government-wide statements, an expense rather than an asset can be recorded regardless of whether the item was obtained by purchase or gift.

The GASB’s handling of this issue closely parallels rules established by the FASB in its SFAS 116, “Accounting for Contri­butions Received and Contributions Made,” utilized by private not-for-profit organizations.

If a government capitalizes a work of art or other historical treasure, an additional theoret­ical question arises, this time about depreciation. Does the map on display in the museum actually depreciate in value over time? In connection with this type of asset, depreciation is required only if the asset is “exhaustible”—that is, if its utility will be used up by display, edu­cation, or research.

Depreciation is not necessary if the work of art or historical treasure is viewed as being inexhaustible. For example, a bronze statue could well be viewed as an inex­haustible asset according to these guidelines so that depreciation is allowed but not required.

Accounting for Infrastructure Assets and Depreciation:

GASB Statement 34 defines infrastructure assets as “long-lived capital assets that normally are stationary in nature and normally can be preserved for a significantly greater number of years than most capital assets.” Examples include roads, bridges, tunnels, lighting systems, curbing, and sidewalks. Recording infrastructure items as assets was historically an optional practice.

Now, though, new infrastructure costs must be recorded as assets on the government-wide statement of net assets. For the governmental funds, these same costs continue to be recorded as expenditures in the fund-based statements because acquisition and construction create a reduction in current financial resources.

Beyond simply recording new infrastructure items as assets, a state or local government also has to capitalize many infrastructure assets acquired prior to the establishment of government- wide financial statements. A major road system constructed 20 years ago, for example, must be shown as an asset in the government-wide statements. Because cost figures for these earlier acquisitions and constructions may not be readily available, estimations are allowed.

In addi­tion, because approximating the cost of all infrastructure items acquired prior to the initial cre­ation of government-wide statements is virtually impossible, this capitalization requirement is limited to major assets that- (1) were acquired in fiscal years ending after June 30, 1980, or (2) had major renovations, restorations, or improvements since that date.

Depreciation is now required for all capital assets appearing in the government-wide financial statements except for land as well as artworks and historical trea­sures that are deemed to be inexhaustible. The need for depreciation was debated in connec­tion with infrastructure items- Is depreciation appropriate for this type of asset? For example, construction of the Brooklyn Bridge was finished in 1883 at a cost of about $15 million.

That particular piece of infrastructure has operated now for more than 120 years and, with proper maintenance, might well continue to carry traffic for another 120 years. Much the same can be said of many roads, sidewalks, and the like built today. With appropriate repair and main­tenance, such assets could have lives that are almost indefinite. What expected life should New York City use to depreciate the cost incurred in constructing a street such as Fifth Avenue?

Not surprisingly, governments tend to depreciate some of their infrastructure assets over extended periods. The City of Bismarck, North Dakota, uses lives that range from 20 to 100 years whereas the City and County, of Denver, Colorado, depreciates these assets over periods from 6 to 40 years.

However, an alternative to depreciating the cost of eligible infrastructure assets such as the Brooklyn Bridge or Fifth Avenue is available. This method, known as the modified approach, eliminates the need for depreciating infrastructure. If specified guidelines are met, a govern­ment can choose to expense all maintenance costs each year in lieu of recording depreciation.

Additions and improvements must be capitalized, but the cost of maintaining the infrastructure in proper working condition is expensed. Thus, if this method is applied, New York City will directly expense the amount spent on repair and other maintenance of Fifth Avenue so that depreciation of the street’s capitalized cost is not recorded.

Use of the modified approach requires the government to accumulate information about all of the infrastructure assets within either a network or a subsystem of a network. For example, all roads could be deemed a network while state roads, rural roads, and interstate highways might make up three subsystems of that network. Fifth Avenue is probably not a network or a subsystem by itself.

i. For eligible assets, the government must establish a minimum acceptable condition level for the network or subsystem of the network and then maintain documentation that this mini­mum level is being met.

ii. The government must have an asset management system in place to monitor the particular network or subsystem of a network in question. This system should assess the ongoing con­dition of the eligible assets to ensure that they are, indeed, able to operate at the predeter­mined level.

The modified approach does provide a method by which governments can avoid depreciat­ing infrastructure assets such as the Brooklyn Bridge that can have virtually an unlimited life. The issue is, how many governments will go to the trouble of creating the standards and doc­umentation required by this approach simply to avoid recording depreciation expense?

“I am beginning to see more infrastructure-heavy organizations—such as airport authorities, trans­portation authorities, or large states with huge road networks—select the modified approach. However, to date, I have not encountered too many general government entities that have con­sidered using it.”

The Primary Government and Component Units:

Primary Government:

According to governmental accounting, every reporting entity should prepare a comprehen­sive annual financial report. The reporting entity starts with a primary government such as a town, city, county, or state. The CAFR then must also include all funds, activities, organi­zations, agencies, offices, and departments that are not legally separate from the primary government.

However, states and localities often encounter a unique problem: determining which sepa­rate activities should be presented with the primary government as part of the reporting entity. Except in rare cases, a business enterprise such as IBM or Ford Motor Company simply con­solidates all corporations over which it has control.

A state or locality, however, can interact with numerous separate departments, agencies, boards, institutes, commissions, and the like. Should all of these functions be included as either governmental activities or business-type activities within the government’s CAFR? If not, what reporting is appropriate?

The almost unlimited number of activities that can be related to a government raises problems for officials attempting to outline the parameters of the entity being reported. Organizations such as turnpike commissions, port authorities, public housing boards, and downtown development commissions have become commonplace in recent years.

The primary government may have created many of these, but they remain legally separate organizations. Such entities are designed to focus attention on specific issues or problems. They possibly offer better efficiency because of their corporate-style structure.

As an example, in the notes to the financial statements in its 2006 CAFR, the City of Boston, Massachusetts, lists the following separate organizations related to the government but whose financial information had not been included with that of the city:

i. Boston Housing Authority.

ii. Boston Industrial Development Financing Authority.

iii. Boston Water and Sewer Commission.

Conversely, the City of Atlanta, Georgia, at June 30, 2006, indicated a number of activities that were legally separate from the city government but were still presented within that city’s finan­cial information.

These included:

i. Atlanta Empowerment Zone Corporation.

ii. Atlanta Development Authority.

iii. Atlanta Clean City Commission.

Clearly, these two examples show that activities related to a government can be included with or excluded from the information produced by the primary government. Some method of stan­dardization is needed.

Because of the extremely wide variety of possible activities, determining which functions actually comprise a state or locality is not always an easy task.

According to paragraphs 2 and 8 of GASB Statement 14, “The Financial Reporting Entity,” the major criterion for inclusion in a government’s comprehensive annual financial report is financial accountability:

Financial reporting based on accountability should enable the financial statement reader to focus on the body of organizations that are related by a common thread of accountability to the con­stituent citizenry. Elected officials are accountable to those citizens for their public policy decisions, regardless of whether these decisions are carried out directly by the elected officials through the operations of the primary government or by their designees through the operations of specially created organizations.

Component Units:

Some activities are legally separate from a primary government but still so closely connected that omission from the statements of that primary government cannot be justified. Because of the rela­tionship, elected officials of the primary government are financially accountable for these sepa­rate organizations known as component units. That is why the City of Atlanta included the Atlanta Empowerment Zone Corporation and those other activities in its CAFR; they were viewed as component units. They are not part of the government but are reported by the government.

Despite being legally separate, component units are included within the financial statements of the primary government to indicate that the connection is close enough to warrant being part of the reporting entity. Thus, identification of such activities can be quite important. Two sets of criteria have been established. If either of these is met, the activity qualifies as a component unit to be reported within the CAFR of the primary government. The parameters of the reporting entity are designed to include both the primary government and any component units.

Criterion 1:

The separate organization (such as the Atlanta Empowerment Zone) is viewed as a component unit if it fiscally depends on the primary government (the City of Atlanta). As defined, fiscal dependency means that the organization cannot do one or more of the following without approval of the primary government: adopt its own budget, levy taxes or set rates, or issue bonded debt.

Criterion 2:

First, officials of the primary government must appoint a voting majority of the governing board of the separate organization. Second, either the primary government must be able to impose its will on the board of the separate organization or that organization provides a finan­cial benefit or imposes a financial burden on the primary government.

For example, a state (the primary government) might establish a commission to oversee off- track betting as a separate legal entity. However, if the state appoints a voting majority of the board membership and the financial benefits from revenues generated by the commission accrue to the state, the commission is considered a component unit of the state for reporting purposes.

Three aspects of the second criterion should be explained to ensure proper application:

1. Voting Majority of the Governing Board:

The authority to elect a voting majority must be substantive. If, for example, the primary government simply confirms the choices that other parties make, financial accountability is not present. In the same way, financial accountability does not result when the primary government must select the governing board from a limited slate of candidates (such as picking three individuals from an approved list of five). Thus, the primary government must have the actual responsibility of appointing a voting majority of the board before the organization meets this portion of the second criterion.

2. Imposition of the Primary Government’s Will on the Governing Board:

Such power is indi­cated if the government can significantly influence the programs, projects, activities, or level of services the organization provides. This degree of influence is present if the primary gov­ernment can remove an appointed board member at will, modify or approve budgets, override decisions of the board, modify or approve rate or fee changes, and hire or dismiss the individ­uals responsible for day-to-day operations.

3. Financial Benefit or Financial Burden on the Primary Government:

A financial connec­tion exists between the organization and the primary government if the government is entitled to the organization’s resources, the government is legally obligated to finance any deficits or provide support, or the government is responsible for the organization’s debts.

Reporting Component Units:

Component units are reported in one of two ways: discrete or blended presentation. Many component units are discretely presented at the far right side of the government-wide state­ments. For example, the September 30, 2005, Statement of Net Assets for the City of Dallas, Texas, shows that the primary government had total assets of more than $7.8 billion whereas its discretely presented component units just to the right of the primary government reported total assets of $688 million.

These activities are identified in the notes to the city’s financial statements:

The following legally separate entities are reported as discretely presented component units of the City because the City appoints a voting majority of the boards, approves budgets, and main­tains the ability to impose its will on the entities.

i. Housing Finance Corporation-organized to issue tax-exempt mortgage revenue bonds to encourage low- to moderate-income citizens’ opportunities for single-family residential home ownership.

ii. Housing Acquisition and Development Corporation-organized solely and exclusively for the public purpose of providing safe, affordable housing facilities for low- and moderate-income persons.

As an alternative placement, a primary government can include component units as an actual part of the reporting government (a process referred to as blending). Although legally separate, the component is so intertwined with the primary government that inclusion is necessary to appropriately present the financial information.

In discussing the reporting of several separate entities related to the City of Saint Paul, the notes to the 2005 financial statements explain that the “following component units have been presented as blended component units because the component units’ governing bodies are the same as the governing body of the City.”

One other aspect of the overall reporting process should be noted- the possible existence of related organizations. In such cases, the primary government is accountable because it appoints a voting majority of the outside organization’s governing board. However, fiscal dependency as defined earlier is not present, and the primary government cannot impose its will on the board or gather financial benefits or burdens from the relationship.

The organization does not qualify as a component unit to be included in the government’s financial reporting. However, the primary government must still disclose the nature of the relationship. That is the rationale for the disclosure by the City of Boston, about its related organizations.

The Mayor is also responsible for appointing members of the governing board of the Boston Housing Authority, Boston Industrial Development Finance Authority, and Boston Water and Sewer Commission; however, the City’s accountability for these organizations does not extend beyond making these appointments.

Special Purpose Governments:

Cities, counties, states, and the like are known as general purpose governments. They provide a wide range of services such as police protection, road repair, and sanitation. They are primary governments, each within its own reporting entity. However, activities that qualify as special purpose governments are also viewed as primary governments for separate reporting purposes.

Thousands of special purpose governments exist throughout the country; they carry out only a single function for the public or a limited number of functions. For example, the 2003 financial statements for the Seattle Popular Monorail Authority state that “financial statement presentation follows accounting principles defined for special-purpose governments.” As such, even though it is not a government in the traditional sense, this Authority must follow the GASB’s accounting and reporting pronouncements.

When reporting a single activity, such as a monorail authority, independent school system, or water control board, the question arises as to whether it is- (1) part of a larger government such as a city or county as either a fund or a component unit, (2) a not-for-profit organization, or (3) a special purpose government that produces its own financial statements according to governmental accounting principles.

Any activity or function is deemed a special purpose government if it meets the following criteria. For example, a school system that satisfies all three is reported as a special purpose government that produces its own financial statements. However, if that school system fails to meet any one of these, its financial condition and operations are likely to be maintained within the General Fund or Special Revenue Funds of a city or county government.

To be a special purpose government, the activity or function must:

1. Have a separately elected governing body.

2. Be legally independent, which it can demonstrate by having corporate powers such as the right to sue and be sued as well as the right to buy, sell, and lease property in its own name.

3. Be fiscally independent of other state and local governments.

An activity is normally considered to be fiscally independent if its leadership can determine the activity’s budget without having to seek the approval of an out­side party, levy taxes or set rates without having to seek outside approval, and issue bonded debt without outside approval.

The comprehensive annual financial report for the Charlotte-Mecklenburg County, North Carolina, Board of Education shows total expenses for the year ended June 30, 2006, of more than $1.1 billion as a special purpose government.