The Basic Of Lease Accounting

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The Basic Of Lease Accounting

  1. 1. 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 ELA Lease Accountants Conference 2004
  2. 2. 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 ELA Lease Accountants Conference 2004
  3. 3. 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 ELA Lease Accountants Conference 2004
  4. 4. 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 ELA Lease Accountants Conference 2004
  5. 5. 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 ELA Lease Accountants Conference 2004
  6. 6. 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 ELA Lease Accountants Conference 2004
  7. 7. 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 ELA Lease Accountants Conference 2004
  8. 8. 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 ELA Lease Accountants Conference 2004
  9. 9. 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 ELA Lease Accountants Conference 2004
  10. 10. 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 ELA Lease Accountants Conference 2004
  11. 11. 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 ELA Lease Accountants Conference 2004
  12. 12. 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 ELA Lease Accountants Conference 2004
  13. 13. 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 ELA Lease Accountants Conference 2004
  14. 14. 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 ELA Lease Accountants Conference 2004 $20,000
  15. 15. Operating Lease Example 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 ELA Lease Accountants Conference 2004 36 mo
  16. 16. Operating Lease Example 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 ELA Lease Accountants Conference 2004 (CR.) $2,222 $2,500 $2,500
  17. 17. Operating Lease Example Financial Statements Income Statement Year 1 Lease income $ Depreciation expense Pre-tax income 36,000 Year 2 $ (26,667) $ 9,333 36,000 ELA Lease Accountants Conference 2004 $ (26,667) $ 9,333 Note: Example ignores income taxes and interest cost to fund asset. 17 Year 3 36,000 (26,666) $ 9,334
  18. 18. Operating Lease Example 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 ELA Lease Accountants Conference 2004 18,666 $ 118,666 28,000 $ 128,000
  19. 19. 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 ELA Lease Accountants Conference 2004
  20. 20. 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 ELA Lease Accountants Conference 2004
  21. 21. Direct Finance Lease Example Assumptions: Fair market value $100,000 Equipment cost $100,000 Monthly rent Term in months Estimated residual value Lessor classification: Direct finance lease because PV of MLPs ≥90% of FMV 21 ELA Lease Accountants Conference 2004 $3,700 36 $20,000
  22. 22. Direct Finance Lease Example 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 ELA Lease Accountants Conference 2004 (Residual value) 53,197 80,003
  23. 23. Direct Finance Lease Example 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 ELA Lease Accountants Conference 2004
  24. 24. Direct Finance Lease Example 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 ELA Lease Accountants Conference 2004 $3,700
  25. 25. Direct Finance Lease Example Financial Statements 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 Note: Example ignores income taxes and interest cost to fund asset. 25 ELA Lease Accountants Conference 2004
  26. 26. Direct Finance Lease Example Financial Statements (cont.) Balance Sheet Year 1 Cash $ 44,400 Year 2 $ 88,800 Year 3 $ 133,200 Investment in leases: • Contracts receivable 88,800 44,440 -- • Unguaranteed residual 20,000 20,000 20,000 • Unearned income (28,802) (10,459) -- Net lease investment 79,998 53,941 20,000 Total assets $ 124,398 $ 142,741 $ 153,200 Common stock $ 100,000 $ 100,000 $ 100,000 Retained earnings Total liabilities and equity 24,398 $ 124,398 26 ELA Lease Accountants Conference 2004 42,741 $ 142,741 53,200 $ 153,200
  27. 27. 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 ELA Lease Accountants Conference 2004
  28. 28. Sales-Type Lease Example Assumptions: Fair market value Equipment cost Monthly rent $100,000 $95,000 $3,700 Term in months Estimated residual value Lessor classification: 36 $20,000 Sales-type lease because PV of MLPs ≥90% of FMV and $5,000 dealer profit 28 ELA Lease Accountants Conference 2004
  29. 29. Sales-Type Lease Example Lessor Accounting entries: Record investment: DR. Contracts receivable 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 Contracts receivable Month #2: Unearned income $3,700 $2,195 Lease income Cash $2,195 $3,700 Contracts receivable 29 ELA Lease Accountants Conference 2004 $3,700
  30. 30. Sales-Type Lease Example Financial Statements Income Statement Year 1 Sales-type gain $ Lease income Pre-tax income 5,000 Year 2 $ 24,398 $ 29,398 -- ELA Lease Accountants Conference 2004 $ 18,343 $ 18,343 Note: Example ignores income taxes and interest cost to fund asset. 30 Year 3 -10,459 $ 10,459
  31. 31. Sales-Type Lease Example Financial Statements (cont.) Balance Sheet Year 1 Cash $ 44,400 Year 2 $ 88,800 Year 3 $ 133,200 Investment in leases: • Contracts receivable 88,800 44,440 -- • Unguaranteed residual 20,000 20,000 20,000 • Unearned income (28,802) (10,459) -- Net lease investment 79,998 53,941 20,000 Total assets $ 124,398 $ 142,741 $ 153,200 Common stock $ 95,000 $ 95,000 $ 95,000 Retained earnings Total liabilities and equity 23,398 $ 124,398 31 ELA Lease Accountants Conference 2004 47,741 $ 142,741 58,200 $ 153,200
  32. 32. 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 ELA Lease Accountants Conference 2004
  33. 33. Questions??? 33 ELA Lease Accountants Conference 2004

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