The Basics 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

Course Outline

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Definition of a lease

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The lease versus buy decision

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Types of leases

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Lease classification

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Lease examples

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Accounting treatment of leases

What Is a Lease?

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An agreement that conveys the right to use

property, generally for a specified period of time

•

Parties to a lease are…

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Lessor—owner of the asset who receives payments

Lease Versus Buy

For lessees…

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To reduce the cost of

capital

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To manage taxes

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To obtain 100% financing

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To manage assets

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Potential off-balance sheet

treatment

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To gain convenience and

efficiency

For lessors…

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Retain tax advantages of

asset ownership to shelter

income

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Retain residual value

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Provide creative financing

alternatives

Types of Leases

Lessee’s point of view…

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Operating lease

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Capital lease

Lessor’s point of view…

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Operating lease

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Direct finance lease

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Sales-type lease

Lease Classification

Criteria

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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

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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…

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Collectibility is reasonably assured

Criteria #2

Bargain Purchase Option

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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 #3

75% Test

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Lease term—fixed, non-cancelable term during which the

lessee can be compelled to make payments plus…

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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

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Periods covered by ordinary renewal options preceding a

bargain purchase option

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Any periods covered by a bargain renewal option

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Estimated useful life—estimated remaining period during

which the asset is expected to be economically useful

Criteria #4

90% Test

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Minimum lease payments (MLPs) include…

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The payments required or expected to be made by the

lessee during the lease term

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Amounts guaranteed by the lessee, plus (lessors only)

amounts guaranteed at inception by third parties

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Penalties the lessee must pay for failure to renew or

extend

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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

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MLPs do not include contingent rentals

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These are rent payments that are not fixed but are

dependent on other factors or circumstances

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The rate used in present valuing the MLPs by…

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The lessor is the implicit rate

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The lessee is the incremental borrowing rate unless the

implicit rate is known

Operating Leases

Balance Sheet

No asset or liability recorded

Leased asset is recorded at cost

and is included in or near

property, plant and equipment,

net of accumulated depreciation

Lessee

Lessor

Operating Leases

Income Statement

N/A

Initial direct costs (IDCs) are

deferred and amortized again

income over the lease term

N/A

Depreciation 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)

Lessee

Lessor

Operating Leases

Disclosures

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/A

Cost or carrying amount and

accumulated depreciation

Lessee

Lessor

Operating Lease Example

Operating lease because PV of MLPs <90% of FMV

Lessor classification:

$20,000 Estimated residual value

36 Term in months $3,500 • Months 25-36 $3,000 • Months 13-24 $2,500 • Months 1-12 Monthly rent: $100,000 Equipment cost $100,000 Fair market value (FMV)

Operating Lease Example

Less: residual value

$100,000 =

Equipment cost Monthly depreciation expense:

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

Operating Lease Example

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

rent] $2,500 Cash* (months 1-12) $2,222 Accumulated depreciation $2,222 Depreciation expense $3,000 Lease income $3,000 Accrued rent Monthly: $100,000 Cash [to book asset]

$100,000 Operating lease cost

Record investment:

(CR.) DR.

Lessor Accounting entries:

Operating Lease Example

Financial 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 36,000 36,000 36,000 Lease income

Income Statement

Operating Lease Example

Financial Statements (cont.)

28,000 18,666 9,333 Retained earnings 100,000 $ 100,000 $ 100,000 $ Common stock 128,000 $ 118,666 $ 109,333 $ Total assets --6,000 6,000 Accrued rents 20,000 46,666 73,330 Net lease investment

(80,000) (53,334) (26,667) • Accumulated deprecation 100,000 100,000 100,000

• Operating lease cost

$ Year 3 $ Year 2 $ Year 1 Investment in leases: 108,000 66,000 30,000 Cash

Balance Sheet

Direct Finance or Capital Leases

Balance 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

Lessee

Capital Lease

Lessor

Direct Finance or Capital Leases

Income 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

Lessee

Capital Lease

Lessor

Direct Finance Lease Example

Direct finance lease because PV of MLPs _{≥≥≥≥90% of FMV}

Lessor classification:

$20,000 Estimated residual value

36 Term in months $3,700 Monthly rent $100,000 Equipment cost $100,000 Fair market value

Direct Finance Lease Example

Direct Finance Lease Example

Total income for

year 1 = $24,398

Direct Finance Lease Example

$3,700 Cash

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

$2,228 Unearned income Month #1: $20,000 Unguaranteed residual $133,200 Contracts receivable* Record investment: (CR.) DR. Lessor Accounting entries:

Direct Finance Lease Example

Financial Statements

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

10,459 $ 18,343 $ 24,398 $ Pre-tax income $ Year 3 $ Year 2 $ Year 1 10,459 18,343 24,398 Lease income

Income Statement

Direct Finance Lease Example

Financial Statements (cont.)

20,000 20,000 20,000 • Unguaranteed residual 53,200 42,741 24,398 Retained earnings 100,000 $ 100,000 $ 100,000 $ Common stock 153,200 $ 142,741 $ 124,398 $ Total assets 20,000 53,941 79,998 Net lease investment

--(10,459) (28,802) • Unearned income --44,440 88,800 • Contracts receivable $ Year 3 $ Year 2 $ Year 1 Investment in leases: 133,200 88,800 44,400 Cash

Balance Sheet

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

Sales-Type Lease Example

Sales-type lease because PV of MLPs _{≥≥≥≥90% of FMV and $5,000}

dealer profit Lessor classification:

$20,000 Estimated residual value

36 Term in months $3,700 Monthly rent $95,000 Equipment cost $100,000 Fair market value

Sales-Type Lease Example

Sales-Type Lease Example

Financial Statements

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

10,459 $ 18,343 $ 29,398 $ Pre-tax income $ Year 3 $ Year 2 $ Year 1 --5,000 Sales-type gain

Income Statement

Sales-Type Lease Example

Financial Statements (cont.)

20,000 20,000 20,000 • Unguaranteed residual 153,200 $ 142,741 $ 124,398 $

Total liabilities and equity

58,200 47,741 23,398 Retained earnings 95,000 $ 95,000 $ 95,000 $ Common stock 153,200 $ 142,741 $ 124,398 $ Total assets 20,000 53,941 79,998 Net lease investment

--(10,459) (28,802) • Unearned income --44,440 88,800 • Contracts receivable $ Year 3 $ Year 2 $ Year 1 Investment in leases: 133,200 88,800 44,400 Cash

Balance Sheet

Return on Investment Comparison

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This demonstrates why lessors strive to achieve direct finance

lease classification

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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

$89,999 Average investment balance

$10,459 $18,343

$24,398 Pre-tax income

Direct finance lease

28% 16%

11% Return on average investment

$33,333 $60,000

$86,667 Average investment balance

$9,334 $9,333 $9,333 Pre-tax income Operating lease Year 3 Year 2 Year 1