the basics of lease accounting - equipment leasing and ... · pdf filethe basics of lease...

ELA Lease Accountants Conference 20041


The Basics ofLease Accounting

Joe Sebik, VP - Global Originations & Structuring J. P. Morgan Leasing, Inc.

(212) 899 - [email protected]

Howard Thompson, Director - Pricing & EconomicsKey Equipment Finance

(518) 257 – [email protected]


Course Outline

• Definition of a lease• The lease versus buy decision• Types of leases• Lease classification• Lease examples

• Accounting treatment of leases

• Q&A


What Is a Lease?

• An agreement that conveys the right to use property, generally for a specified period of time

• Parties to a lease are…• Lessor—owner of the asset who receives payments• Lessee—user of the asset who makes payments


Lease Versus Buy

For lessees…• To reduce the cost of

capital• To manage taxes• To obtain 100% financing• To manage assets• Potential off-balance sheet

treatment• To gain convenience and

efficiency

For lessors…• Retain tax advantages of

asset ownership to shelter income

• Retain residual value• Provide creative financing

alternatives


Types of Leases

Lessee’s point of view…• Operating lease• Capital lease

Lessor’s point of view…• Operating lease• Direct finance lease• Sales-type lease• Leveraged lease


Lease ClassificationCriteria

• A lease is a finance or capital lease if it meets any one of the following criteria…

1. Lease transfers title2. Lease contains a bargain purchase option3. Lease term is ≥≥≥≥75% of the estimated useful life of the leased asset4. Present value of the minimum lease payments is ≥≥≥≥90% of the fair

value of the leased asset• In addition to the lease criteria, a lease must meet both of the

following in order for a lessor to classify it as a finance lease…• Collectibility is reasonably assured• No important uncertainties exist concerning any future obligations

of the lessor


Criteria #2Bargain Purchase Option

• An option price that is considered to be sufficiently below expected fair value (the sale price in an arms-length transaction) so as to make the exercise of the option appear to be reasonably assured at inception


Criteria #375% Test

• Lease term—fixed, non-cancelable term during which the lessee can be compelled to make payments plus…

• All periods for which failure to renew the lease imposes a penalty on the lessee in such amounts that a renewal appears to be reasonably assuredOR

• Periods covered by ordinary renewal options preceding a bargain purchase option

• Any periods covered by a bargain renewal option

• Estimated useful life—estimated remaining period during which the asset is expected to be economically useful


Criteria #490% Test

• Minimum lease payments (MLPs) include…• The payments required or expected to be made by the

lessee during the lease term• Amounts guaranteed by the lessee, plus (lessors only)

amounts guaranteed at inception by third parties• Penalties the lessee must pay for failure to renew or

extend

• A penalty is any requirement of the lessee to disburse cash, incur or assume a liability, perform services, surrender or transfer an asset, or right to an asset, or otherwise forego an economic benefit or suffer an economic detriment


Criteria #4 (cont.)90% Test

• MLPs do not include contingent rentals• These are rent payments that are not fixed but are

dependent on other factors or circumstances

• The rate used in present valuing the MLPs by…• The lessor is the implicit rate• The lessee is the incremental borrowing rate unless the

implicit rate is known


Operating LeasesBalance Sheet

No asset or liability recordedLeased asset is recorded at cost and is included in or near property, plant and equipment, net of accumulated depreciation

LesseeLessor


Operating LeasesIncome Statement

N/AInitial direct costs (IDCs) are deferred and amortized again income over the lease term

N/ADepreciation recorded in accordance with company’s depreciation policy

Lease expense recognized on a straight-line basis over life of the lease (accrue rent expense if rents are uneven)

Lease income recognized on a straight-line basis over life of the lease (accrue rent income if rents are uneven)

LesseeLessor

IDCs are costs incurred by the lessor in negotiating the lease transaction (e.g., commissions, legal fees, etc.)


Operating LeasesDisclosures

Minimum future rentals in total for each of the next 5 years and total

Minimum future rentals in total for each of the next 5 years and total

N/ACost or carrying amount and accumulated depreciation

LesseeLessor


Operating Lease Example

Operating lease because PV of MLPs <90% of FMVLessor classification:

$20,000Estimated residual value36Term in months

$3,500• Months 25-36$3,000• Months 13-24$2,500• Months 1-12

Monthly rent:$100,000Equipment cost$100,000Fair market value (FMV)Assumptions:



$2,222=36 mo÷$80,000=Total depreciation

($20,000)=Less: residual value$100,000=Equipment costMonthly depreciation expense:

$3,000=36 mo÷$108,000=Total$42,000=12 mox$3,500+$36,000=12 mox$3,000+$30,000=12 mox$2,500Monthly lease income:



*Amounts should reflect actual cash flows

$2,500Accrued rent* (months 1-12) [collection of rent]

$2,500Cash* (months 1-12)

$2,222Accumulated depreciation

$2,222Depreciation expense

$3,000Lease income

$3,000Accrued rentMonthly:

$100,000Cash [to book asset]

$100,000Operating lease costRecord investment:

(CR.)DR.Lessor Accounting entries:


Operating Lease ExampleFinancial Statements

Note: Example ignores income taxes and interest cost to fund asset.

9,334$9,333$9,333$Pre-tax income

$Year 3

$Year 2

$Year 1

(26,666)(26,667)(26,667)Depreciation expense

36,00036,00036,000Lease income

Income Statement


Operating Lease ExampleFinancial Statements (cont.)

128,000$118,666$109,333$Total liabilities and equity28,00018,6669,333Retained earnings100,000$100,000$100,000$Common stock

128,000$118,666$109,333$Total assets--6,0006,000Accrued rents

20,00046,66673,330Net lease investment(80,000)(53,334)(26,667)• Accumulated deprecation100,000100,000100,000• Operating lease cost

$Year 3

$Year 2

$Year 1

Investment in leases:108,00066,00030,000Cash

Balance Sheet


Direct Finance or Capital LeasesBalance Sheet

Asset is included in or near property, plant and equipment, net of accumulated depreciation

Investment consists of:1. Sum of the MLPs, including

any residual value guarantees and

2. The estimated residual value

Investment in asset and obligation is recorded at an amount equal to the present value of the MLPs

Investment in the lease is recorded at FMV, FMV = carrying cost

LesseeCapital Lease

LessorDirect Finance Lease


Direct Finance or Capital LeasesIncome Statement

Lessee payments over the lease term are prorated between interest expense and the reduction of the obligations

Initial direct costs are deferred and amortized into income over the lease term

Depreciation on the asset is recorded in accordance with the company’s depreciation policy

Lease income recognized to produce a constant rate of return on the investment balance over the life of the lease

LesseeCapital Lease

LessorDirect Finance Lease


Direct Finance Lease Example

Direct finance lease because PV of MLPs ≥≥≥≥90% of FMVLessor classification:


$3,700Monthly rent$100,000Equipment cost$100,000Fair market valueAssumptions:



80,00353,197TOTALS2,1891,51167,82719(Residual value)19,997372,1411,55969,96918

3,18451623,180362,0951,60572,064173,11458626,295352,0491,65174,113163,04665429,341342,0041,69676,117152,98072032,321331,9611,73978,078142,91578535,236321,9181,78279,996132,85284838,088311,8761,82481,872122,78991140,877301,8351,86583,708112,72997143,606291,7951,90585,503102,6691,03146,275281,7561,94487,26092,6111,08948,886271,7181,98288,97882,5541,14651,440261,6812,01990,65873,4991,20153,939251,6442,05692,30262,4441,25656,383241,6082,09293,91052,3911,30958,774231,5732,12795,48342,3391,36161,113221,5392,16197,02232,2881,41263,400211,5052,19598,52822,2381,46265,638201,4732,228100,0001

Principal Paydown

Interest EarnedAsset ValueMo

Principal Paydown


Implicit rate = 26.73%Monthly payment = $3,700



1,8761,82481,872121,8351,86583,708111,7951,90585,503101,7561,94487,26091,7181,98288,97881,6812,01990,65871,6442,05692,30261,6082,09293,91051,5732,12795,48341,5392,16197,02231,5052,19598,52821,4732,228100,0001

Principal Paydown


Monthly payment = $3,700

Total income for year 1 = $24,398



$2,195Unearned incomeMonth #2:

$2,195Lease income

$3,700Cash

$3,700Contracts receivable

$100,000Cash

$53,200Unearned income

*Total rents 36 months x $3,700 = $133,200

$3,700Contracts receivable [to book rent received]

$3,700Cash

$2,228Lease income ([to book income]


$20,000Unguaranteed residual

$133,200Contracts receivable*Record investment:



Direct Finance Lease Example Financial Statements


10,459$18,343$24,398$Pre-tax income

$Year 3

$Year 2

$Year 1

10,45918,34324,398Lease income

Income Statement


Direct Finance Lease Example Financial Statements (cont.)

20,00020,00020,000• Unguaranteed residual


153,200$142,741$124,398$Total assets20,00053,94179,998Net lease investment

--(10,459)(28,802)• Unearned income

--44,44088,800• Contracts receivable

$Year 3

$Year 2

$Year 1


Balance Sheet


Sales-Type LeasesAccounting

• Same as direct finance lease except FMV is not equal to carrying cost

• Difference between FMV and carrying cost is recognized as a gain or loss at the inception of the lease


Sales-Type Lease Example

Sales-type lease because PV of MLPs ≥≥≥≥90% of FMV and $5,000 dealer profit

Lessor classification:


$3,700Monthly rent$95,000Equipment cost

$100,000Fair market valueAssumptions:


Sales-Type Lease Example

$95,000Inventory


$2,195Lease income

$3,700Cash


$5,000Sales-type gain

$53,200Unearned income


$3,700Cash

$2,228Lease income


$20,000Unguaranteed residual

$133,200Contracts receivableRecord investment:



Sales-Type Lease Example Financial Statements

10,45918,34324,398Lease income


10,459$18,343$29,398$Pre-tax income

$Year 3

$Year 2

$Year 1

----5,000Sales-type gain

Income Statement


Sales-Type Lease Example Financial Statements (cont.)

20,00020,00020,000• Unguaranteed residual


153,200$142,741$124,398$Total assets20,00053,94179,998Net lease investment

--(10,459)(28,802)• Unearned income

--44,44088,800• Contracts receivable

$Year 3

$Year 2

$Year 1


Balance Sheet


Return on Investment Comparison

• This demonstrates why lessors strive to achieve direct finance lease classification

• The earnings pattern is more consistent through the term of the lease (not back ended)

27%27%27%Return on average investment

$36,971$66,970$89,999Average investment balance$10,459$18,343$24,398Pre-tax incomeDirect finance lease

28%16%11%Return on average investment

$33,333$60,000$86,667Average investment balance$9,334$9,333$9,333Pre-tax incomeOperating lease

Year 3Year 2Year 1


Questions???

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