What Are Minimum Lease Payments?
Let me explain what minimum lease payments are. They're the lowest amount a lessor can expect to receive—and a lessee can expect to pay—over the entire lease period. As an accountant, you calculate these to assign a present value to the lease, ensuring it's recorded correctly in the company's books.
The calculation method comes from the Statement of Financial Accounting Standards No. 13 (FAS 13), Accounting for Leases, issued by the Financial Accounting Standards Board (FASB) back in 1980. This standard lays out how to handle it precisely.
Key Insights on Minimum Lease Payments
Understand that minimum lease payments cover the lowest anticipated amount you'll pay as a lessee for a leased asset or property throughout the term. We use present value calculations to discount those future payments, factoring in the time value of money so the accounting reflects reality.
These estimates also involve a 90% test to check an asset's investment recovery, and this applies whether you're dealing with a capital or operating lease. It's a straightforward way to ensure the lease is classified correctly.
The Formula for Minimum Lease Payments and Lease Valuation
The present value formula includes the minimum lease payments and the overall lease value. Leased equipment typically has a residual value at the end of the term—that's an estimate of what's left in the asset's worth.
Here's the formula you need: PV = ∑[Pmt_i / (1 + r)^i] from i=0 to n + Res / (1 + r)^n, where PV is the present value of the minimum lease payments, Pmt_i is the lease payment for period i, r is the interest rate, n is the number of payment periods, and Res is the residual amount. This captures the discounted value accurately.
What Does Calculating Minimum Lease Payments Tell You?
Calculating minimum lease payments is key to the recovery of investment test, often called the 90% test. This helps decide if a lease goes on the books as operating or capital. The accounting differs based on whether you're the lessee or lessor.
Companies lease equipment when they can't buy it outright or if it has a short useful life. The lessor owns it and rents it out, while the lessee pays regularly. You're expected to cover a minimum during the contract—that's your minimum lease payment.
These payments include rentals over the term, any bargain purchase options, premiums, guaranteed residual values, but exclude lessor costs and contingent rentals. It's a clean definition for accounting purposes.
Special Considerations
You might think a 12-month lease at $1,000 a month totals $12,000 in minimum payments, but clauses can complicate it. Executory costs like maintenance and insurance are usually excluded since the lessor handles them, but other elements add up.
Consider guarantees you make as lessee on the property's residual value at lease end, or penalties for not renewing. Factor these in, and you get a reasonable present value for the lease in your accounting.
Example of Minimum Lease Payments and Present Value
To value a lease, discount the minimum lease payments. Let's walk through an example to see the cost in today's dollars. Suppose a company leases heavy-duty trucks for 3 years.
The minimum payment is $3,000 per month, or $36,000 per year. Interest is 5% annually, which is 0.417% monthly. We also factor in a residual value of $45,000 at the end.
Using the annual discount rate of 5%, the PV calculation is: PV = $36,000 / 1.05^1 + $36,000 / 1.05^2 + $36,000 / 1.05^3 + $45,000 / 1.05^3 = $34,285.71 + $32,653.06 + $31,098.83 + $38,873.53 = $136,911.13.
So, in present terms, this lease costs $136,911.13. That's how you apply it in practice.
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