CAIRNS REGIONAL COUNCIL LEASING GUIDELINES

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1 CAIRNS REGIONAL COUNCIL NO.1:02:46 General Policy LEASING GUIDELINES Intent Scope To ensure that Council: (i) complies with the Leasing in the Queensland Public Sector Policy Guidelines, (revised December 2006); (ii) complies with Australian Accounting Standards; (iii) achieves value for money; (vi) negotiates an appropriate risk return position prior to entering into a leasing arrangement. This policy applies to every lease of an asset, except for a tenancy lease of real property. PROVISIONS The Financial Services Branch must be involved in the evaluation of all lease versus buy decisions. This is necessary due to the inherent complexity not only of the financing arrangements themselves but the subsequent accounting requirements. This policy addresses issues relating to leasing of assets under the Queensland Public Sector Policy Guidelines issued by Queensland Treasury Corporation (QTC): 1. The responsibilities of Council to ensure prudent financial management with regard to the lease vs. buy decision. 2. The distinction between an operating lease and a finance lease and the methodologies, which should be used to classify a lease. 3. The transfer of risk in the residual value of an asset associated with the use of operating leases. 4. Bundling of services in lease transactions. 5. The power of Council to enter into lease arrangements. 6. Lease documentation and other associated issues. 7. The correct budgetary and accounting treatment of expenditures and future commitments under lease arrangements. Philosophy I. Prudent financial management in the lease vs. buy decision Council should ensure that any acquisition decision takes into account value for money, ensuring probity and accountability outcomes. Council should be satisfied that the best cost alternative represents the best return and performance for the money spent from a total costs of ownership or whole-of life costs perspective. Leasing arrangements cannot be used as a means to alleviate the impact of pressure on budget allocations. Failure to adhere to this principle has the potential to constrain future budget flexibility (by creating expenditure commitments in future years) and to significantly compromise Council s financial position.

2 The responsibilities of Council to ensure prudent financial management requires that a decision to enter into either a finance lease or an operating lease be based on a detailed net present value and cost/benefit evaluation of the lease proposal relative to the acquisition alternatives. II. Distinction between operating and finance leases Where a lease proposal is being considered as an acquisition alternative, it is important to understand the distinction between an operating lease and a finance lease and the methodologies that should be used to classify a lease. A lease should not be classified as finance or operating merely because it is labelled as such by the lessor. Whether a lease is a finance or an operating lease depends on the substance of the transaction rather than the form of the contract. Australian Accounting Standard 117 (AASB 117) Leases, requires leases to be classified as either operating or finance leases and specifies accounting treatments and disclosures appropriate for each type of lease. AASB 117 states that a finance lease can be distinguished from an operating lease by determining which party bears the risks and benefits of ownership of the asset and provides guidance in ascertaining which party assumes the risks and benefits of ownership. Council should ensure that leases are appropriately classified in accordance with AASB 117. Finance Lease A finance lease is an agreement, which covers most of the useful life of the asset. The agreement is typically non-cancellable (or cancellable at a significant penalty) and is based on the lessee guaranteeing the residual value of the leased asset at the end of the lease term. It is also where the present value at the beginning of the lease term of the minimum lease payments equals or exceeds 90 per cent of the fair value of the leased asset at the inception of the lease. The lessor usually allows the lessee to buy the formerly leased asset upon payment of a pre-determined residual value. However, a lease can still be classified as a finance lease even if ownership at the end of the lease is not guaranteed. Because the lessee has to make guaranteed lease payments and has to support a guaranteed residual value, the lease is equivalent to debt financing the whole cost of the leased asset. The finance lease structure ensures that the lessor recovers the full cost of the asset and earns its required rate of return over the lease term. Consequently, it is considered similar to a secured borrowing because substantially all the risks and benefits incidental to ownership of the leased asset rest with the lessee, despite legal ownership remaining with the lessor. A finance lease is analogous to a loan and outright purchase for accounting. The lessee s statement of financial performance will show finance lease charges (being the implicit interest rate equivalent) and lease amortisation (equivalent to depreciation) as expense items. Operating Lease An operating lease is essentially a rental agreement. It has a shorter term (75% or less of the economic life of the asset) than a finance lease and may be cancellable without a significant penalty. The lessee does not guarantee any residual value, and at the end of the lease term, the lessee usually must return the asset to the lessor, who will either sell the asset or redeploy it to other end users. All risks and benefits incidental to ownership of the leased asset remain with the lessor. The lessee therefore enjoys the use of the asset without bearing any residual or obsolescence risk. The transfer of risk away from the lessee is usually reflected in higher lease rentals. The lessor also is entitled to any upside or resale or re-lease of a formerly leased asset.

3 Because an operating lease is considered to be a true hiring rather than being analogous to a loan, the leased assets and corresponding lease liabilities do not appear on the balance sheet of the lessee. The lessee s profit and loss statement will show lease rentals paid during the relevant period as an expense item. III. Transfer of risk in the residual value of an asset for operating leases As lease payments under an operating lease ordinarily include a premium for the acceptance of the risk in the asset by the lessor, operating leases generally would be more expensive than a borrowing or finance lease in net present value terms. Where a lessor has developed specialised distribution channels for specific asset classes, the lessors may be able to realise a higher resale price for those assets than the lessee could. The benefit obtained through a higher disposal value for the asset at the end of the term is typically passed through to lessees in the form of reduced lease rentals. IV. Bundling of services in lease transactions Lessors often attempt to bundle additional services (maintenance being one of the most prominent) together with the finance component of their lease transactions under one costing and one contract. These services typically are not provided by the lessor, but by a third party, often under an agency agreement. Two main concerns with the bundling of lease arrangements with additional services are: Lessees would not be in a position to assess costs or benefits and competitiveness of the services and the finance component of the lease independent of one another; and Lessees could lose their ability to seek recourse to the service provider where a problem arose. Therefore, Council should carefully examine the cost of and contractual relationship between the lease component and each of the services in any documentation relating to the lease. Lease quotes should be obtained on an unbundled and separate basis to allow for separate evaluation of each of the components (e.g. the lease of the asset and the maintenance of the asset). Also, the actual lease agreement should only relate to the finance component of the lease. Where a lease proposal includes bundled services, the finance component and the bundled services should be documented separately or alternatively, incorporated as distinct severable sections within the lease agreement. This will ensure that the bundling of different services with the lease does not restrict recourse to the individual providers of the services. If the lessor wishes to provide a bundled quote on the basis that single costing for a complete package of the lease and related services may be cheaper, the quote must include a breakdown outlining the proportions of the quote attributable to the finance component and each of the individual services. The main purpose of this is to specify the cost of individual services for the purpose of recourse under the lease agreement, and if applicable, to enable a net present value comparison between various bundled and unbundled quotes, rather than to require services to be provided on a separate contractual basis or to allow substitution of service providers. V. Consideration of all costs in the lease vs. buy analysis Consideration of all relevant costs requires careful perusal of a prospective lease agreement for any restrictive terms regarding matters such as the timing, method and cost of the return of the asset or equipment.

4 When calculating the cost of the different acquisition alternatives, including leasing and purchasing, any costs involved in installing, operating, maintaining, removing, disposing of or returning an asset, must be taken into account. In the case of commercialised business units, any associated taxation and depreciation issues also should be taken into account. VI. Understanding the calculations in the lease vs. buy analysis Council should ensure prudent financial management whereby any decision to enter into a lease be based on a detailed net present value and cost/benefit evaluation of the lease proposal relative to other acquisition alternatives. This evaluation must include a calculation of all cash flows and costs associated with each of the relevant acquisition alternatives. The cost of the lease first must be compared (on a net present value basis) with other leases to ensure the best value lease is identified. The best value lease proposal then should be compared (on a net present value basis) with the cost of alternative acquisition methods, including borrowing (if permitted by policy) or outright purchase. When comparing bundled lease proposals, the service aspects of the bundled quote would have to be incorporated into the cost calculations of the alternative methods of acquisition. In doing a lease vs. buy analysis, the following bases should be used: Discount Rate use QTC cost of funds applicable to the term of the proposed lease. Debt Finance where the purchase price is funded by debt finance, use QTC cost of funds, including the debt repayments and the residual value over the life of the loan. Budget appropriation where the purchase price is fully funded upfront from a budget appropriation, all cash flows, including the residual value (net of disposal costs) and the cash flow arising from the immediate and full payment of the purchase price, should be used in the net present value calculations. Purchase by instalments where the purchase price is funded over time from budget appropriations, the net present value of all cash flows, including the future payment obligations and the residual value, would need to be calculated using QTC cost of funds. VII. Lease vs. buy decision Finance leases A decision to enter into a finance lease should be made only when the net present value of future cash flows under the best value lease proposal is less than the net present value of cash flows under alternative methods of acquisition. A finance lease will usually involve a greater level of administration than debt financing and the lessor may build a margin into the final price to reflect this. Lessees also tend to underestimate their administration and documentation costs. Therefore it is common for finance leases to be more expensive than debt for lessees. Because finance leases are effectively debt arrangements, the built in cost of funds obtained from lessors is often greater than could be provided under a government loan arrangement. Operating leases Operating lease payments normally include a premium for the acceptance of the risk in the asset by the lessor. Therefore, an operating lease is generally more expensive than a borrowing or finance lease in net present value terms.

5 It is possible to quantify the amount of the premium in an operating lease, so that the lessee may weigh up the value of risk transfer. The premium for an operating lease can be calculated by dividing the difference between the net present value of the lease and purchase alternative by the capital cost of the equipment. An operating lease will represent value for money if the cost premium is commensurate with the risk transfer. A premium of up to 5% of the capital cost of the equipment is generally considered an acceptable cost for the transfer of risk from the lessee to the lessor. If the premium over the purchase option is greater than 5%, there should be sound reasons for further consideration of the proposed transaction. High cost premiums are often associated with non-competitive lease pricing or with items that are not suitable for leasing, i.e equipment that does not retain any future value. If Council wishes to undertake a lease proposal (finance or operating) which does not meet the assessment criteria outlined above, Council should ensure that there are sound reasons for further consideration of the proposal. If Council is satisfied as to the appropriateness of the proposed transaction, the proposal will require QTC approval. The application for approval must be lodged with the Queensland Treasury, complete with details of all acquisition alternatives and the reasons for seeking exemption from the above requirements. VIII. Power to lease The financial powers of local governments generally are derived from the Statutory Bodies Financial Arrangements Act 1982 (SBFA Act). Subject to compliance with the SBFA Act and the Local Government Act 2012, a local government has power to enter into a lease arrangement. This power however requires Treasurer s approval under Part 7A Division 3, Section 60A of SBFA Act. Council should ensure that QTC is invited to quote or tender; and that the most cost effective financing option for the acquisition is adopted. Council is required to approach the Department of Local Government, Community Recovery and Resilience with complete details of the proposal and request that the department see any necessary approval on its behalf. Finance lease Council must seek approval under the State Borrowing Program and the Statutory Bodies Financial Arrangements Act 1982 to enter into a finance lease. In addition, where Council wishes to enter into a finance lease with a cost premium, the lessee will also require Treasury s approval. Operating lease Council must also seek approval under the State Borrowing Program to enter into any operating lease where the net present value of the base lease rental payments exceeds $2 million. This threshold applies to the total value of an individual lease. Under the approval framework, a local government is required to obtain the Treasurer s approval to enter into an operating lease where: The cost premium of the lease over the purchase alternative is greater than 5% of the capital cost of the equipment; and The capital cost of the equipment is greater than $10,000.

6 IX. Lease documentation issues Many operating leases contain a variety of clauses that either are inappropriate for local governments such as requirements for insurance, onerous rights of entry and the right to use the lessee s name in legal actions, or could dramatically increase the cost of leasing for the lessee, hence affecting the outcome of the cost/benefit analysis. Key documentation issues that should be considered during preliminary cost analysis, tender negotiations and subsequent drawdowns include: a) Commencement Date the date the lease agreement commences and the date from which the lessee must pay lease rentals. It is common practice for lessors to set the commencement date in a manner that maximises the amount of any interim rentals. b) Interim rentals - lessors commonly nominate payment dates that preclude the commencement of rental terms on days other than the specified payment dates. Where a lessee takes delivery of equipment prior to a nominated payment date, an interim rental (above the base lease rental) will be required. c) End of term provisions as with interim rentals, the end of term provision in a lease can provide lessors with an additional mechanism for mitigating their residual risk in the lease asset. These provisions generally are drafted such that the lessee must continue to lease the equipment if the asset return provisions are not met. d) Upgrades despite the claims of lessors, there generally are no specific provisions within lease documentation regarding the upgrade of lease equipment. Upgrading effectively involves a termination of the existing lease, after which the lessee leases back the upgraded equipment for an extended term. A termination in this manner can allow the lessor to make windfall profits. e) Termination Value the amount due from the lessee where the lease terminates prior to the end of the normal lease term. The major concern is that the lessee often has no method for verifying its calculation. Accordingly, potential exists for the lessor to exploit lessees when an early termination occurs. f) Indemnities some lessors require lessees to provide non-standard indemnities relating to any changes in the treatment of the lease for tax purposes. X. Budgetary treatment of lease payments Finance leases should be capitalised and the relevant expenditure should be funded from capital budget allocations. An operating lease effectively constitutes a rental agreement, for which the relevant expenditure should be met from recurrent budget allocations. The attached procedure is a guideline for use when considering leasing decisions. This policy is to remain in force until otherwise determined by Council. Manager Responsible for Review: General Manager Corporate Services ORIGINALLY ADOPTED:29/01/2004 CURRENT ADOPTION: 26/06/2013 DUE FOR REVISION: 26/06/2017 REVOKED/SUPERSEDED:

7 Leasing Procedure The following steps should be read in conjunction with the flowchart shown in Step 4. Step 1: Gather Lease Quotes This entails gathering lease quotes for the item of capital equipment to be acquired. The QTC Leasing Manager must be invited to tender. Failure to do so will make an application for leasing invalid. Quotes can also be obtained from other leasing companies if desired. The QTC Leasing Facility handles all items of capital equipment except passenger motor vehicles. It is generally not ideal to enter into lease arrangements for photocopiers, IT equipment and yellow plant (bulldozers, loaders, etc.). Photocopiers and IT equipment generally have economic lives not exceeding two years due to the rapid technological changes. Yellow plant may be leased where there is a specific dedicated use for a project and the plant is deemed to have no other future use. Step 2: Undertake Lease vs. Buy Analysis Using the QTC s Asset Financing Model a) Value check In determining value for money, compare the lease option vs the cost of purchase option using QTC s Asset Financing Model (available in the QTC website: Login is required for access to QTCConnect). b) Value of buying To determine the cost of purchasing the equipment outright (buy), the QTC Asset Financing Model: determines the net present value of the equipment cost at the valuation date, and then subtracts the expected residual value (lessee s assumption) discounted back to the valuation date. The expected residual value is subtracted because it is a cash inflow rather than an outflow. c) Value of leasing To determine the net present value of an operating lease, the QTC Asset Financing Model discounts the lease payments back to the valuation date. d) Comparing your options The net present value of buying the asset with debt funding is then compared against the net present value of the lease payments. If the net present value to buy is less than the net present value of leasing, then leasing includes a premium. The value for money test is not achieved if the cost premium is not commensurate with the risk transfer of the lease. A premium of up to 5% of the capital cost of the equipment is generally considered an acceptable cost for the transfer of risk from the lessee to the lessor.

8 e) Implicit lease rate The implicit lease rate is defined in AASB 117 as the interest rate that equates the present value at the beginning of the lease term, of: the minimum lease payments (ie, lease payment over the lease term and any guaranteed payment by the lessee to the lessor in respect to the residual value of the equipment or any bargain purchase option) any unguaranteed residual value expected to accrue to the benefit of the lessor at the end of the lease term, and to the fair value of the leased asset at the inception of the lease. The lower the implicit lease rate, the lower the lease payment. Note that the implicit lease rate is extremely dependent on the residual value assumption. Step 3: Classification of Lease as Operating or Finance Lease Under AASB 117, the classification of a lease as operating or finance relies more heavily on risk transfer and substance over form. The indicative tests are: 90% test 75% test, and Substance over form test. 90% test - involves determining whether the discounted lease rental payments and any guaranteed residual value equals or exceeds 90% of the fair value of the leased asset at the beginning of the lease term. If the present value equals or exceeds 90% then the lease may fail to qualify as an operating lease. The rate used to discount the lease rental payments to the present is the implicit lease rate of the cost of funds. Due to the reluctance of lessors to provide details of their internal pricing, the implicit lease rate will only be accurate if the lessee is able to make a reliable estimate of the residual value. In circumstances where the lessee is unable to estimate the residual value reliably, the lessee is required to use the lessee s borrowing rate. 75% test involves determining whether the lease term exceeds 75% of the economic life of the leased asset. If the lease term equals or exceeds 75%, then the lease may fail to qualify as an operating lease. Substance over form test - based on the wider test of who bears substantially all the risks and benefits incidental to ownership in the leased assets. As the 90% and 75% tests are indicative only and the overriding test is a question of who bears the risks and benefits in the leased equipment, it is necessary to make a subjective determination of the lease classification based on this wider test. It is suggested that independent accounting advice be obtained on this issue if necessary, as the test depends on substance over form.

9 Step 4: Approval Required The provisions under the policy must be followed in ensuring that the relevant approval framework is followed.

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