Appendix B: Leveraged Leases Under US GAAP

One of the most complex accounting subjects regarding leases is the accounting for a leveraged lease. Once again, as with both sales-type and direct financing, the classification of the lease by the lessor has no effect on the accounting treatment accorded the lease by the lessee. The lessee simply treats it as any other lease and thus is interested only in whether the lease qualifies as an operating or a capital lease. The lessor's accounting problem is substantially more complex than that of the lessee.

To qualify as a leveraged lease, a lease agreement must meet the following requirements, and the lessor must account for the investment tax credit (when in effect) in the manner described below.

Note

Failure to do so will result in the lease being classified as a direct financing lease.

1. The lease must meet the definition of a direct financing lease. (The 90% of FMV criterion does not apply.) ^[2]

2. The lease must involve at least three parties.

   1. An owner-lessor (equity participant)

   2. A lessee

   3. A long-term creditor (debt participant)

3. The financing provided by the creditor is nonrecourse as to the general credit of the lessor and is sufficient to provide the lessor with substantial leverage.

4. The lessor's net investment (defined below) decreases in the early years and increases in the later years until it is eliminated.

The last characteristic (item 4) poses the accounting problem.

The leveraged lease arose as a result of an effort to maximize the tax benefits associated with a lease transaction. To accomplish this, it was necessary to involve a third party to the lease transaction (in addition to the lessor and lessee), a long-term creditor. The following diagram illustrates the existing relationships in a leveraged lease agreement:

1. The owner-lessor secures long-term financing from the creditor, generally in excess of 50% of the purchase price. US GAAP indicates that the lessor must be provided with sufficient leverage in the transaction; thus the 50%.

2. The owner then uses this financing along with his or her own funds to purchase the asset from the manufacturer.

3. The manufacturer delivers the asset to the lessee.

4. The lessee remits the periodic rent to the lessor.

5. The debt is guaranteed by either using the equipment as collateral, the assignment of the lease payments, or both, depending on the demands established by the creditor.

The FASB concluded that the entire lease agreement be accounted for as a single transaction and not a direct financing lease plus a debt transaction. The feeling was that the latter did not readily convey the net investment in the lease to the user of the financial statements. Thus, the lessor is to record the investment as a net amount. The gross investment is calculated as a combination of the following amounts:

1. The rentals receivable from the lessee, net of the principal and interest payments due to the long-term creditor

2. A receivable for the amount of the investment tax credit (ITC) to be realized on the transaction (repealed in the United States but may yet exist in other jurisdictions)

3. The estimated residual value of the leased asset

4. The unearned and deferred income, consisting of

   1. The estimated pretax lease income (or loss), after deducting initial direct costs, remaining to be allocated to income

   2. The ITC remaining to be allocated to income over the remaining term of the lease

The first three amounts described above are readily obtainable; however, the last amount, the unearned and deferred income, requires additional computations. To derive this amount, it is necessary to create a cash flow (income) analysis by year for the entire lease term. As described in item 4 above, the unearned and deferred income consists of the pretax lease income (Gross lease rentals - Depreciation - Loan interest) and the unamortized investment tax credit. The total of these two amounts for all the periods in the lease term represents the unearned and deferred income at the inception of the lease.

The amount computed as the gross investment in the lease (foregoing paragraphs) less the deferred taxes relative to the difference between pretax lease income and taxable lease income is the net investment for purposes of computing the net income for the period. To compute the periodic net income, another schedule must be completed that uses the cash flows derived in the first schedule and allocates them between income and a reduction in the net investment.

The amount of income is first determined by applying a rate to the net investment. The rate to be used is the rate that will allocate the entire amount of cash flow (income) when applied in the years in which the net investment is positive. In other words, the rate is derived in much the same way as the implicit rate (trial and error), except that only the years in which there is a positive net investment are considered. Thus, income is recognized only in the years in which there is a positive net investment.

The income recognized is divided among the following three elements:

1. Pretax accounting income

2. Amortization of investment tax credit

3. The tax effect of the pretax accounting income

The first two are allocated in proportionate amounts from the unearned and deferred income included in calculation of the net investment. In other words, the unearned and deferred income consists of pretax lease accounting income and any investment tax credit. Each of these is recognized during the period in the proportion that the current period's allocated income is to the total income (cash flow). The last item, the tax effect, is recognized in the tax expense for the year. The tax effect of any difference between pretax lease accounting income and taxable lease income is charged (or credited) to deferred taxes.

When tax rates change, all components of a leveraged lease must be recalculated from the inception of the lease, using the revised after-tax cash flows arising from the revised tax rates.

If, in any case, the projected cash receipts (income) are less than the initial investment, the deficiency is to be recognized as a loss at the inception of the lease. Similarly, if at any time during the lease period the aforementioned method of recognizing income would result in a future period loss, the loss shall be recognized immediately.

This situation may arise as a result of the circumstances surrounding the lease changing. Therefore, any estimated residual value and other important assumptions must be reviewed on a periodic basis (at least annually). Any change is to be incorporated into the income computations; however, there is to be no upward revision of the estimated residual value.

The following example illustrates the application of these principles to a leveraged lease.

Example of simplified leveraged lease

Assume the following:

1. A lessor acquires an asset for $100,000 with an estimated useful life of 3 years in exchange for a $25,000 down payment and a $75,000 3-year note with equal payments due on 12/31 each year. The interest rate is 18%.

2. The asset has no residual value.

3. The PV of an ordinary annuity of $1 for 3 years at 18% is 2.17427.

4. The asset is leased for 3 years with annual payments due to the lessor on 12/31 in the amount of $45,000.

5. The lessor uses the ACRS method of depreciation for tax purposes and elects to reduce the ITC rate to 4%, as opposed to reducing the depreciable basis.

6. Assume a constant tax rate throughout the life of the lease of 40%.

Chart 1 analyzes the cash flows generated by the leveraged leasing activities. Chart 2 allocates the cash flows between the investment in leveraged leased assets and income from leveraged leasing activities. The allocation requires finding that rate of return which, when applied to the investment balance at the beginning of each year that the investment amount is positive, will allocate the net cash flow fully to net income over the term of the lease. This rate can be found only by a computer program or by an iterative trial-and-error process. The example that follows has a positive investment value in each of the 3 years, and thus the allocation takes place in each time period. Leveraged leases usually have periods where the investment account turns negative and is below zero.

Allocating principal and interest on the loan payments is as follows:

$75,000 2.17427 = $34,494

Year	Payment	Interest 18%	Principal	Balance
Inception of lease	$ --	$ --	$ --	$75,000
1	34,494	13.500	20,994	54,006
2	34,494	9,721	24,773	29,233
3	34,494	5,261	29,233	--

Chart 1

	A	B	c	D	E	F	G	H	I
	Rent	Depr.	Interest on loan	Taxable income (A-B-C)	Income tax payable (revbl.) Dx40%	Loan principal payments	ITC	Cash flow (A+G-C-E-F)	Cumulative cash flow
Initial	$ --	$ --	$ --	$ --	$ --	$ --	$ --	$(25,000)	$(25,000)
Year 1	45,000	25,000	13,500	6,500	2,600	20,994	4,000	11,906	(13,094)
Year 2	45,000	38,000	9,721	(2,721)	(1,088)	24,773	--	11,594	(1,500)
Year 3	45,000	37,000	5,261	2,739	1,096	29,233	--	9,410	7,910
Total	$135,000	$100,000	$28,482	$ 6,518	$2,608	$75,000	$4,000	$7,910

The chart below allocates the cash flows determined above between the net investment in the lease and income. Recall that the income is then allocated between pretax accounting income and the amortization of the investment for credit. The income tax expense for the period is a result of applying the tax rate to the current periodic pretax accounting income.

The amount to be allocated in total in each period is the net cash flow determined in column H above. The investment at the beginning of year 1 is the initial down payment of $25,000. This investment is then reduced on an annual basis by the amount of the cash flow not allocated to income.

Chart 2

	1	2	3	4	5	6	7
		Cash Flow Assumption				Income Analysis
	Investment beginning of year	Cash flow	Allocated to investment	Allocated to income	Pretax income	Income tax expense	Investment tax credit
Year 1	$25,000	$11,906	$ 7,964	$3,942	$3,248	$1,300	1,994
Year 2	17,036	11,594	8,908	2,686	2,213	885	1,358
Year 3	8,128	9,410	8,128	1,282	1,057	423	648
		$32,910	$25,000	$7,910	$6,518	$2,608	$4,000
Rate of return = 15.77%

1. Column 2 is the net cash flow after the initial investment, and columns 3 and 4 are the allocation based on the 15.77% rate of return. The total of column 4 is the same as the total of column H in Chart 1.

2. Column 5 allocates column D in Chart 1 based on the allocations in column 4. Column 6 allocates column E in Chart 1, and column 7 allocates column G in Chart 1 in the same basis.

The journal entries below illustrate the proper recording and accounting for the leveraged lease transaction. The initial entry represents the cash down payment, investment tax credit receivable, the unearned and deferred revenue, and the net cash to be received over the term of the lease.

The remaining journal entries recognize the annual transactions that include the net receipt of cash and the amortization of income.

	Year 1		Year 2		Year 3
Rents receivable [Chart 1 (A-C-F)]	31,518
Investment tax credit receivable	4,000
Cash		25,000
Unearned and deferred income		10,518
[Initial investment, Chart 2 (5+7) totals]
Cash	10,506		10,506		10,506
Rent receivable		10,506		10,506		10,506
[Net for all cash transactions. Chart 1 (A-C-F) line by line for each year]
Income tax receivable (cash)	4,000
Investment tax credit receivable		4,000
Unearned and deferred income	5,242		3,571		1,705
Income from leveraged leases		5,242		3,571		1,705
[Amortization of unearned income, Chart 2 (5+7) line by line for each year]

The following schedules illustrate the computation of deferred income tax amount. The annual amount is a result of the temporary difference created due to the difference in the timing of the recognition of income for book and tax purposes. The income for tax purposes can be found in column D in Chart 1, while the income for book purposes is found in column 5 of Chart 2. The actual amount of deferred tax is the difference between the tax computed with the temporary difference and the tax computed without the temporary difference. These amounts are represented by the income tax payable or receivable as shown in column E of Chart 1 and the income tax expense as shown in column 6 of Chart 2. A check of this figure is provided by multiplying the difference between book and tax income by the annual rate.

Year 1
Income tax payable	$ 2,600
Income tax expense	(1,300)
Deferred income tax (Dr)		$1,300
Taxable income	$ 6,500
Pretax accounting income	(3,248)
Difference $3,252 x 40% = $1,300	$ 3,252

Year 2
Income tax receivable	$ 1,088
Income tax expense	885
Deferred income tax (Cr)		$ 1,973
Taxable loss	$ 2,721
Pretax accounting income	2,213
Difference $4,934 x 40% = $1,973	$ 4,934

Year 3
Income tax payable	$ 1,096
Income tax expense	(423)
Deferred income tax (Dr)		$ 673
Taxable income	$ 2,739
Pretax accounting income	(1,057)
Difference $ 1,682 x 40% = $673	$.1,682

^[2]A direct financing lease must have its cost or carrying value equal to the fair value of the asset at the inception of the lease. Thus, even if the amounts are not significantly different, leveraged lease accounting should not be used.