Leases and Lease Structure Issues

MEMO Date: July 18, 2011 3 Subject: Leases and Lease Structure Issues 4 To: Regional Trucking Company 5 From: Bob Stanton This memo will cover the current practice and thought related to direct financing, sales type, and operating leases. I understad that Regional Trucking Company have limited time to cover all aspects of these areas. Disclosure Requirements for Capital Leases SFAS No. 13 also requires the disclosure of additional information for capital leases.

The following information must be disclosed in the lessee’s financial statements or in the accompanying footnotes: 1. The gross amount of assets recorded under capital leases as of the date of each balance sheet presented by major classes according to nature or function 2. Future minimum lease payments as of the date of the latest balance sheet presented, in the aggregate and for each of the five succeeding fiscal years 3. The total minimum sublease rentals to be received in the future under noncancelable subleases as of the date of the latest balance sheet presented 4.

Total contingent rentals (rentals on which the amounts are dependent on some factor other than the passage of time) actually incurred for each period for which an income statement is presented. The lessor should report a lease as a sales-type lease when at least one of the capital lease criteria is met, both lessor certainty criteria are met, and there is a manufacturer’s or dealer’s profit (or loss). Major steps are involved in accounting for a sales-type lease by a lessor.

The amount to be recorded as gross investment is the total amount of the minimum lease payments over the life of the lease, plus any unguaranteed residual value accruing to the benefit of the lessor. Once the gross investment has been determined, it is to be discounted to its present value using an interest rate that causes the aggregate present value at the beginning of the lease term to be equal to the fair value of the leased property. The rate thus determined is referred to as the interest rate implicit in the lease

Applying the interest method results in a constant rate of return on the net investment in the lease. The difference between the gross investment and the unearned interest income is the amount of net investment, which is equal to the present value of the gross investment. The net investment is classified as a current or noncurrent asset on the lessor’s balance sheet in the same manner as all other assets. Income from sales-type leases is thus reflected by two amounts. 1.

The gross profit (or loss) on the sale in the year of the lease agreement 2. Interest on the remaining net investment over the life of the lease agreement. When at least one of the capital lease criteria and both lessor certainty criteria are met, but the lessor has no manufacturer’s or dealer’s profit (or loss), lessors account for the lease as a direct financing lease. As with a sales-type lease, each payment received for a direct financing lease must be allocated between interest revenue and recovery of the net investment.

Because the net receivable is essentially an installment loan, in the early periods of the lease a significant portion of the payment is recorded as interest; but each succeeding payment will result in a decreasing amount of interest revenue and an increasing amount of investment recovery because the amount of the net investment is decreasing. Gross investment is determined in the same way as in sales-type leases, but unearned income is computed as the difference between gross investment and the cost of the leased property.

The difference between gross investment and unearned income is net investment, which is the same as in the sales-type lease. Initial direct costs in financing leases are treated as an adjustment to the investment in the leased asset. In each accounting period over the life of the lease, the unearned interest income minus the indirect cost is amortized by the effective interest method. Because the net investment is increased by an amount equal to the initial direct costs, a new effective interest rate must be determined in order to apply the interest method to he declining net investment balance. Lessees classify all leases that do not meet any of the four capital lease criteria as operating leases. The following disclosures are required for operating leases by lessees: 1. For operating leases having initial or remaining noncancelable lease terms in excess of one year: a. Future minimum rental payments required as of the date of the latest balance sheet presented in the aggregate and for each of the five succeeding fiscal years b.

The total of minimum rentals to be received in the future under noncancelable subleases as of the date of the latest balance sheet presented 2. For all operating leases, rental expense for each period for which an income statement is presented, with separate amounts for minimum rentals, contingent rentals, and sublease rentals 3. A general description of the lessee’s leasing arrangements including, but not limited to, the following: a. The basis on which contingent rental payments are determined b.

The existence and terms of renewals or purchase options and escalation clauses c. Restrictions imposed by lease agreements, such as those concerning dividends, additional debt, and further leasing Those leases that do not meet the criteria for classification as sales-type or direct financing leases are accounted for as operating leases by the lessor. As a result, the lessor’s cost of the leased property is reported with or near other property, plant, and equipment on the lessor’s balance sheet and is depreciated following the lessor’s normal depreciation policy.

Rental payments are recognized as revenue when they become receivable unless the payments are not made on a straight-line basis. In that case, as with the lessee, the recognition of revenue is to be on a straight-line basis. Initial direct costs associated with the lease are to be deferred and allocated over the lease term in the same manner as rental revenue (usually on a straight-line basis). However, if these costs are not material, they may be charged to expense as incurred.

The best course of action is to first choose a capital lease. It would probably be best if your company would buy the trucks at a later date. Since, the company is looking to lease, and probably at some point buy more trucks at some time in the future, the company should lease with an option to buy. The biggest worry that the company has is time. This being said, the best lease type to present is the sales-type lease.