Post on 16-Apr-2017
ELA Lease Accountants Conference 20041
ELA Lease Accountants Conference 2004
The Basics ofLease Accounting
Joe Sebik, VP - Global Originations & Structuring J. P. Morgan Leasing, Inc.
(212) 899 - 1249joseph.p.sebik@jpmorgan.com
Howard Thompson, Director - Pricing & EconomicsKey Equipment Finance
(518) 257 – 8248howard.k.thompson@key.com
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Course Outline
• Definition of a lease• The lease versus buy decision• Types of leases• Lease classification• Lease examples
• Accounting treatment of leases
• Q&A
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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.)
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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
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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:
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Operating Lease Example
$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:
ELA Lease Accountants Conference 200416
Operating Lease Example
*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:
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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
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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
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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
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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
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Direct Finance Lease Example
Direct finance lease because PV of MLPs ≥≥≥≥90% of FMVLessor classification:
$20,000Estimated residual value36Term in months
$3,700Monthly rent$100,000Equipment cost$100,000Fair market valueAssumptions:
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Direct Finance Lease Example
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
Interest EarnedAsset ValueMo
Implicit rate = 26.73%Monthly payment = $3,700
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Direct Finance Lease Example
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
Interest EarnedAsset ValueMo
Monthly payment = $3,700
Total income for year 1 = $24,398
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Direct Finance Lease Example
$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]
$2,228Unearned incomeMonth #1:
$20,000Unguaranteed residual
$133,200Contracts receivable*Record investment:
(CR.)DR.Lessor Accounting entries:
ELA Lease Accountants Conference 200425
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
10,45918,34324,398Lease income
Income Statement
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Direct Finance Lease Example Financial Statements (cont.)
20,00020,00020,000• Unguaranteed residual
153,200$142,741$124,398$Total liabilities and equity53,20042,74124,398Retained earnings100,000$100,000$100,000$Common stock
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
Investment in leases:133,20088,80044,400Cash
Balance Sheet
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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
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Sales-Type Lease Example
Sales-type lease because PV of MLPs ≥≥≥≥90% of FMV and $5,000 dealer profit
Lessor classification:
$20,000Estimated residual value36Term in months
$3,700Monthly rent$95,000Equipment cost
$100,000Fair market valueAssumptions:
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Sales-Type Lease Example
$95,000Inventory
$2,195Unearned incomeMonth #2:
$2,195Lease income
$3,700Cash
$3,700Contracts receivable
$5,000Sales-type gain
$53,200Unearned income
$3,700Contracts receivable
$3,700Cash
$2,228Lease income
$2,228Unearned incomeMonth #1:
$20,000Unguaranteed residual
$133,200Contracts receivableRecord investment:
(CR.)DR.Lessor Accounting entries:
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Sales-Type Lease Example Financial Statements
10,45918,34324,398Lease income
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
----5,000Sales-type gain
Income Statement
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Sales-Type Lease Example Financial Statements (cont.)
20,00020,00020,000• Unguaranteed residual
153,200$142,741$124,398$Total liabilities and equity58,20047,74123,398Retained earnings95,000$95,000$95,000$Common stock
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
Investment in leases:133,20088,80044,400Cash
Balance Sheet
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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
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Questions???