We are looking at reagent agreements for the hospital where the vendor locks in the price on various reagents if we commit to a minimum purchase quantity each year. The vendor also "gives" us the processing instrument/equipment for the reagents - they build the cost of the equipment into our minium purchase quantity.
The problem arises when we are evaluating these agreements to classify them for
A second, different problem occurs when an agreement is classified as a capital lease and there are no regular payments on the lease - we might buy the entire year's minimum purchase quantity in one month, or buy different amounts each month.
Your input and comments are greatly appreciated!
Reagent agreements - capital lease?
Answers
Perhaps I am mis-reading this. Do you mean that you are buying consumable materials (the reagents) on a minimum quantity basis per year, and your vendor is giving you the processing equipment "for free" although the cost of that equipment is built into your consumables fee?
If that is the case, I don't see how that is a lease in any case because you are not "leasing" the equipment. You seem to be paying for the consumable and that is all. If Pepsi were to lend you a soda machine for free so that you could sell its sodas in your store, you would not be "leasing" the soda machine, even if you paid Pepsi an extra $.02/can of soda sold.
Capital Lease: A lease that meets one or more of the following criteria, meaning it is classified as a purchase by the lessee: the lease term is greater than 75% of the property's estimated economic life; the lease contains an option to purchase the property for less than fair market value; ownership of the property is transferred to the lessee at the end of the lease term; or the present value of the lease payments exceeds 90% of the fair market value of the property.
Operating Lease: A lease for which the lessee acquires the property for only a small portion of its useful life. An operating lease is commonly used to acquire equipment on a short-term basis. Any lease that is not a capital lease is an operating lease.
If I'm missing the boat, please clarify.
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Mark, hi. Thanks for your comments. Sorry, I forgot to include some important facts . . . . . the vendor gives us title to the equipment for $1 at the end of the lease. We will be using the equipment for more than 75% of its useful life (5 years).
The lease appears to meet the tests for a capital lease, but it still a confusing designation. If the vendor refuses to specify what portion of the payment relates to the cost of the equipment, we can't create the amortizaton schedule that capital leases require.
We may not buy the supplies in the same amount each month, hence not receiving monthly invoices or invoices that are the same amount each month. How to match that up to an amortization schedule?
What to do with the consummable part?
Thanks again for considering this question.
Would the appropriate schedule be based upon the purchasing forecast you developed and then adjust once real purchases where made? We offer these same concepts to our hospital customers, as unbudgeted capital expense is hard to get approved. But we do get a committed "blanket PO" which can be rescheduled but not cancelled. So that blanket seems to serve as the basis for an amortization? Some part of the purchase is allocated to the expense budget, the remainder goes against the lease?
Are there other terms in the agreement? For example what happens if you terminate the contract early - specific payment for the equipment or simply a return of the equipment? At the end of the fixed period if you renew, will you get new equipment? Are charges for the equipment assessed and separately stated? Are there additional charges for sales
Allan makes good points. Also if there is no resale market value for the equipment then its FAS157 fair value is near zero, which again argues for incidental treatment of the equipment with the reagent expense recognized as incurred.
Given the bargain purchase ($1.00 at the end of the period) and the length of the agreement (more than 75% of the useful life), it's fairly clear that you have a capital lease.
To value the equipment, I would look at alternative vendors. Where could you find similar equipment if your contracted vendor went out of business and new equipment was needed? And, how much would it cost? This can be used to impute the "cost" of the equipment.
To write-off the equipment, you can simply straight-line it over the period of the agreement. While some sort of usage based write-off is also possible, this can sharply increase the amount of effort -- especially if the useful life (in terms of usage) is not know and/or you don't have records that tell you exactly how many times it is used.
I wouldn't be particularly concerned about the "payment" schedule (i.e., if you purchase a lot of reagents this quarter and none next quarter). Depreciation/amortization is to be a systematic and logical means of recording cost over time, and does not necessarily reflect the "actual" reduction in value for any given period.
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Ray, the problem is how would she build up the value to be depreciated? Presumably she would have to put up a lease payable amount, and amortize that against payments for the reagents as purchase. I have a problem putting this liability on the books as it could / would not be able to be confirmed as payable. Again to the question of what happens at early termination.
Of course I am being practical. Practical and GAAP don't always play well together.
Allan,
I think the key in this one is to read the final contract. Presumably there would be periodic minimum purchases and verbiage as to what happens in the event of early termination.
Unless the contract is a loss leader for the reagant seller, the annual minimum should cover the cost of both the reagants and equipment, so there should be enough to "divide". Even if there isn't, the cost can still be booked.
Another way of approaching it would be to look at the cost of the reagants with another vendor. The difference should reflect the implied cost of the equipment.
Another possibility is to ask the vendor for the names of other hospitals out of the area that have used the reagents/equipment. I've found that CFOs of non-competing firms have been very willing to offer brief insight and counsel.