The Basic Of Lease Accounting

ELA Lease Accountants Conference 2004

The Basics of
Lease Accounting
Joe Sebik, VP - Global Originations & Structuring
J. P. Morgan Leasing, Inc.
(212) 899 - 1249
joseph.p.sebik@jpmorgan.com
Howard Thompson, Director - Pricing & Economics
Key Equipment Finance
(518) 257 – 8248
howard.k.thompson@key.com

1

Course Outline
• Definition of a lease
• The lease versus buy decision
• Types of leases
• Lease classification
• Lease examples
• Accounting treatment of leases

• Q&A

2

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

3

Lease Versus Buy
For lessees…

For lessors…

• To reduce the cost of
capital
• To manage taxes

• Retain tax advantages of
asset ownership to shelter
income

• To obtain 100% financing

• Retain residual value

• To manage assets

• Provide creative financing
alternatives

• Potential off-balance sheet
treatment
• To gain convenience and
efficiency

4

Types of Leases
Lessee’s point of view…

Lessor’s point of view…

• Operating lease

• Operating lease

• Capital lease

• Direct finance lease
• Sales-type lease
• Leveraged lease

5

Lease Classification
Criteria
• A lease is a finance or capital lease if it meets any one of the
following criteria…
1. Lease transfers title
2. Lease contains a bargain purchase option
3. Lease term is ≥75% of the estimated useful life of the leased asset
4. 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

6

Criteria #2
Bargain 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

7

Criteria #3
75% 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 assured
OR
• 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

8

Criteria #4
90% 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
9

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

10

Operating Leases
Balance Sheet
Lessor

Lessee

Leased asset is recorded at cost
and is included in or near
property, plant and equipment,
net of accumulated depreciation

No asset or liability recorded

11

Operating Leases
Income Statement
Lessor

Lessee

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

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

Depreciation recorded in
accordance with company’s
depreciation policy

N/A

Initial direct costs (IDCs) are
deferred and amortized again
income over the lease term

N/A

IDCs are costs incurred by the lessor
in negotiating the lease transaction
(e.g., commissions, legal fees, etc.)
12

Operating Leases
Disclosures
Lessor

Lessee

Cost or carrying amount and
accumulated depreciation

N/A

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

13

Operating Lease Example
Assumptions:

Fair market value (FMV)

$100,000

Equipment cost

$100,000

Monthly rent:
• Months 1-12

$2,500

• Months 13-24

$3,000

• Months 25-36

$3,500

Term in months

36

Estimated residual value
Lessor classification:

Operating lease because PV of MLPs <90% of FMV

14

$20,000

Monthly lease income:

$2,500

x

12 mo

=

$30,000

+

$3,000

x

12 mo

=

$36,000

+

$3,500

x

12 mo

=

$42,000

Total

=

$108,000

36 mo

=

$3,000

Equipment cost

=

$100,000

Less: residual value

=

($20,000)

Total depreciation

=

$80,000

=

$2,222

÷
Monthly depreciation expense:

÷

15

36 mo

Lessor Accounting
entries:
Record investment:

DR.
Operating lease cost

$100,000

Cash [to book asset]
Monthly:

Accrued rent

$100,000
$3,000

Lease income
Depreciation expense

$3,000
$2,222

Accumulated depreciation
Cash* (months 1-12)
Accrued rent* (months 1-12) [collection of
rent]

*Amounts should reflect actual cash flows

16

(CR.)

$2,222
$2,500
$2,500

Financial Statements
Income Statement
Year 1
Lease income

$

Depreciation expense
Pre-tax income

36,000

Year 2
$

(26,667)
$

9,333

36,000


$

(26,667)
$

9,333

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

17

Year 3
36,000
(26,666)
$

9,334

Financial Statements (cont.)
Balance Sheet
Year 1
Cash

$

30,000

Year 2
$

66,000

Year 3
$

108,000

Investment in leases:
• Operating lease cost

100,000

100,000

100,000

• Accumulated deprecation

(26,667)

(53,334)

(80,000)

Net lease investment

73,330

46,666

20,000

Accrued rents

6,000

6,000

--

Total assets

$

109,333

$

118,666

$

128,000

Common stock

$

100,000

$

100,000

$

100,000

Retained earnings
Total liabilities and equity

9,333
$

109,333

18

18,666
$

118,666

28,000
$

128,000

Direct Finance or Capital Leases
Balance Sheet
Lessor
Direct Finance Lease
Investment in the lease is
recorded at FMV, FMV = carrying
cost

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

Investment consists of:

Asset is included in or near
1. Sum of the MLPs, including
property, plant and equipment,
any residual value guarantees net of accumulated depreciation
and
2. The estimated residual value

19

Direct Finance or Capital Leases
Income Statement
Lessor
Direct Finance Lease

Lessee
Capital Lease

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

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

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

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

20

Direct Finance Lease Example
Assumptions:

Fair market value

$100,000

Equipment cost

$100,000

Monthly rent
Term in months

Direct finance lease because PV of MLPs ≥90% of FMV

21

$3,700
36
$20,000

Monthly payment = $3,700
Mo

Asset Value

Interest
Earned

Implicit rate = 26.73%
Principal
Paydown

Mo

Asset Value

Interest
Earned

Principal
Paydown

1

100,000

2,228

1,473

20

65,638

1,462

2,238

2

98,528

2,195

1,505

21

63,400

1,412

2,288

3

97,022

2,161

1,539

22

61,113

1,361

2,339

4

95,483

2,127

1,573

23

58,774

1,309

2,391

5

93,910

2,092

1,608

24

56,383

1,256

2,444

6

92,302

2,056

1,644

25

53,939

1,201

3,499

7

90,658

2,019

1,681

26

51,440

1,146

2,554

8

88,978

1,982

1,718

27

48,886

1,089

2,611

9

87,260

1,944

1,756

28

46,275

1,031

2,669

10

85,503

1,905

1,795

29

43,606

971

2,729

11

83,708

1,865

1,835

30

40,877

911

2,789

12

81,872

1,824

1,876

31

38,088

848

2,852

13

79,996

1,782

1,918

32

35,236

785

2,915

14

78,078

1,739

1,961

33

32,321

720

2,980

15

76,117

1,696

2,004

34

29,341

654

3,046

16

74,113

1,651

2,049

35

26,295

586

3,114

17

72,064

1,605

2,095

36

23,180

516

3,184

18

69,969

1,559

2,141

37

19,997

19

67,827

1,511

2,189

TOTALS

22

(Residual value)
53,197

80,003

Monthly payment = $3,700
Mo

Asset Value

Interest
Earned

Principal
Paydown

1

100,000

2,228

1,473

2

98,528

2,195

1,505

3

97,022

2,161

1,539

4

95,483

2,127

1,573

5

93,910

2,092

1,608

6

92,302

2,056

1,644

7

90,658

2,019

1,681

8

88,978

1,982

1,718

9

87,260

1,944

1,756

10

85,503

1,905

1,795

11

83,708

1,865

1,835

12

81,872

1,824

1,876

Total income for
year 1 = $24,398
23

Lessor Accounting
entries:
Record investment:

DR.
Contracts receivable*
Unguaranteed residual

$133,200
$20,000

Cash

$100,000

Unearned income
Month #1:

Unearned income

$53,200
$2,228

Lease income ([to book income]
Cash

$2,228
$3,700

Contracts receivable [to book rent received]
Month #2:

Unearned income

$3,700
$2,195

Lease income
Cash

$2,195
$3,700

Contracts receivable

24

(CR.)

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

$3,700

Income Statement
Year 1

Year 2

Year 3

Lease income

$

24,398

$

18,343

$

10,459

Pre-tax income

$

24,398

$

18,343

$

10,459


25

Balance Sheet
Year 1
Cash

$

44,400

Year 2
$

88,800

Year 3
$

133,200

• Contracts receivable

88,800

44,440

--

• Unguaranteed residual

20,000

20,000

20,000

• Unearned income

(28,802)

(10,459)

--


79,998

53,941

20,000

Total assets

$

124,398

$

142,741

$

153,200

Common stock

$

100,000

$

100,000

$

100,000

Retained earnings

24,398
$

124,398

26

42,741
$

142,741

53,200
$

153,200

Sales-Type Leases
Accounting
• 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

27

Sales-Type Lease Example
Assumptions:

Fair market value
Equipment cost
Monthly rent

$100,000
$95,000
$3,700

Term in months

36
$20,000

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

28

Lessor Accounting
entries:
Record investment:

DR.
Unguaranteed residual

(CR.)

$133,200
$20,000

Sales-type gain

$5,000

Inventory
Unearned income
Month #1:

$95,000
$53,200

Unearned income

$2,228

Lease income
Cash

$2,228
$3,700

Month #2:

Unearned income

$3,700
$2,195

Lease income
Cash

$2,195
$3,700

29

$3,700

Income Statement
Year 1
Sales-type gain

$

Lease income
Pre-tax income

5,000

Year 2
$

24,398
$

29,398

--


$

18,343
$

18,343


30

Year 3
-10,459
$

10,459

Balance Sheet
Year 1
Cash

$

44,400

Year 2
$

88,800

Year 3
$

133,200

• Contracts receivable

88,800

44,440

--

• Unguaranteed residual

20,000

20,000

20,000

• Unearned income

(28,802)

(10,459)

--


79,998

53,941

20,000

Total assets

$

124,398

$

142,741

$

153,200

Common stock

$

95,000

$

95,000

$

95,000

Retained earnings

23,398
$

124,398

31

47,741
$

142,741

58,200
$

153,200

Return on Investment Comparison
Year 1
Operating lease

Pre-tax income

Year 2

Year 3

$9,333

$9,333

$9,334

$86,667

$60,000

$33,333

11%

16%

28%

Pre-tax income

$24,398

$18,343

$10,459

Average investment balance

$89,999

$66,970

$36,971

27%

27%

27%

Average investment balance
Return on average investment
Direct finance lease

Return on average investment

• 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)

32

Questions???

33

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