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
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ELA Lease Accountants Conference 2004
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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ELA Lease Accountants Conference 2004
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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ELA Lease Accountants Conference 2004
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
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ELA Lease Accountants Conference 2004
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
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ELA Lease Accountants Conference 2004
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
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ELA Lease Accountants Conference 2004
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
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ELA Lease Accountants Conference 2004
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
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ELA Lease Accountants Conference 2004
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
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ELA Lease Accountants Conference 2004
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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ELA Lease Accountants Conference 2004
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
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ELA Lease Accountants Conference 2004
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.)
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ELA Lease Accountants Conference 2004
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
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ELA Lease Accountants Conference 2004
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
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ELA Lease Accountants Conference 2004
$20,000
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:
÷
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ELA Lease Accountants Conference 2004
36 mo
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
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ELA Lease Accountants Conference 2004
(CR.)
$2,222
$2,500
$2,500
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.
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Year 3
36,000
(26,666)
$
9,334
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
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ELA Lease Accountants Conference 2004
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
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ELA Lease Accountants Conference 2004
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
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ELA Lease Accountants Conference 2004
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
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ELA Lease Accountants Conference 2004
$3,700
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$20,000
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
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ELA Lease Accountants Conference 2004
(Residual value)
53,197
80,003
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
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ELA Lease Accountants Conference 2004
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
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(CR.)
*Total rents 36 months x $3,700 = $133,200
ELA Lease Accountants Conference 2004
$3,700
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.
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ELA Lease Accountants Conference 2004
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
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ELA Lease Accountants Conference 2004
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
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ELA Lease Accountants Conference 2004
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
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ELA Lease Accountants Conference 2004
Sales-Type Lease Example
Lessor Accounting
entries:
Record investment:
DR.
Contracts receivable
Unguaranteed residual
$133,200
$20,000
Sales-type gain
Month #1:
$5,000
Inventory
$95,000
Unearned income
$53,200
Unearned income
$2,228
Lease income
Cash
$2,228
$3,700
Contracts receivable
Month #2:
(CR.)
Unearned income
$3,700
$2,195
Lease income
Cash
$2,195
$3,700
Contracts receivable
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ELA Lease Accountants Conference 2004
$3,700
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.
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Year 3
-10,459
$
10,459
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
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ELA Lease Accountants Conference 2004
47,741
$
142,741
58,200
$
153,200
Return on Investment Comparison
Year 1
Operating lease
Pre-tax income
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
Year 2
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)
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ELA Lease Accountants Conference 2004
Questions???
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ELA Lease Accountants Conference 2004