Lease Accounting: Lease Accounting: Residual Value ReviewResidual Value Review

Mr. Paul MirkhaniMr. Paul MirkhaniControls/PracticesControls/Practices

IBM Global FinancingIBM Global Financing

OverviewOverview

!GAAP Requirements

!Methodology

!Mechanics

!Summary

Requirements/GuidanceRequirements/Guidance

Capital Leases

"SFAS #13 - Paragraph 17.d. (Sales-Type Leases)ƒ "The estimated residual value shall be reviewed at least

annually. If the review results in a lower estimate than had been previously established..."

"SFAS #13 - Paragraph 18.d. (Direct Financing Leases)ƒ "The estimated residual value shall be reviewed at least

annually and, if necessary, adjusted in the manner prescribed in paragraph 17.d."

Requirements/GuidanceRequirements/Guidance(continued)(continued)

"SFAS #13 - Paragraph 46 (Leveraged Leases)ƒ "Any estimated residual value and all other important

assumptions affecting estimated total net income from the lease shall be reviewed at least annually. If during the lease term the estimate of the residual value is determined to be excessive..."

Requirements/GuidanceRequirements/Guidance(continued)(continued)

Operating Leases

"SFAS #121 Paragraph 51ƒ "The board also agreed that assets of lessor subject to operating leases are within the

scope of this statement.""Long-lived Assets should be periodically Reviewed for impairment when carrying amount may not be recovered"Impairment Indicators (Assets to be Held and Used)

ƒ Significant decrease in the market value of an assetƒ Significant change in the extent or manner an asset is usedƒ Adverse change in legal factorsƒ Accumulation of costs significantly in excess of amount expected to acquire or construct an

assetƒ Current period and history of operating or cash flow losses associated with an asset used

for producing revenue

MethodologyMethodology

"Determine latest End-Of-Lease (EOL) Fair Market Values (FMV)."Compare latest EOL FMV to booked residual values."Identify potential exposures."Temporary or "Other Than Temporary.""Record adjustments, if necessary.

ƒ Upward adjustments not permitted

Reserve/Writedown MethodsReserve/Writedown Methods

"Level of precision helps to identify additional informationƒ Exposures vs. Opportunities

"Recording writedownƒ Adjust each lease recordƒ Maintain top level

"Accounting implementation methodsƒ Current

–Calculate PV of initial and new residual value–Delta represents writedown to current year I&E–Recalculate IIR for remaining Lease Term

Reserve/Writedown MethodsReserve/Writedown Methods(continued)(continued)

ƒ Current & Prospective–Recalculate IIR for entire lease with new RV–Compare finance income recognized to recalculated income

–Delta represents writedown to current year I&E

Current MethodCurrent MethodAssume 2,600,000 ORIG.UI 405,000RV 125,000Projected FMV After Year 100,000IIR 9.28%Monthly Payment 80,000Term 36 Months

FIN INC UI BAL NIBYear 1 210,023 194,977 1,850,023

PV of Original RV (125,000)103,900

PV of New RV (100,000) 83,120Delta 20,780

RV Writedown (20,780) 190,757 1,829,243Year 2 138,289 52,468 1,003,312Year 3 52,468 0 100,000

Total Lease Earnings 380,000

Current Current -- Writedown Expense Today Writedown Expense Today -- Recalculate IIR for Year 2 & 3Recalculate IIR for Year 2 & 3

Current & Prospective MethodCurrent & Prospective MethodAssume 2,600,000 ORIG.UI 405,000RV 125,000Projected FMV After Year 1

100,000IIR 9.28%Monthly Payment 80,000Term 36 Months

FIN INC UI BAL NIBYear 1 210,023 194,977 1,850,023

PV of Original RV (125,000) 210,023

PV of New RV (100,000) 198,572Delta 11,451

RV Writedown (11,451) 181,428 1,838,572Year 2 128,798 52,630 1,007,370Year 3 52,630 0 100,000Total Lease Earnings 380,000Revised IIR 8.80%

Current & Future Current & Future -- Recalculate IIR For Entire Lease Term, Calculate Revised BalancRecalculate IIR For Entire Lease Term, Calculate Revised Balanceses

Lease Earnings By YearLease Earnings By YearWritedown at End of Year 1Writedown at End of Year 1

Year 1 Year 2 Year 3 Year 4

Current 189 138 53 380

Current & Future 198 129 53 380

Capital LeaseCapital Lease($ K)

Operating Lease Equipment and FASB #121Operating Lease Equipment and FASB #121Accounting For the Impairment of LongAccounting For the Impairment of Long--Lived Lived

Assets and Assets to be DisposedAssets and Assets to be Disposed

"Impairment Test - Assets to be held and usedƒ Estimate the future cash flow (undiscounted and with out

interest charges) expected from the use of the asset.ƒ Assets grouped at the lowest level for identifiable cash

flow.ƒ Impairment recognized if future cash flow is less than

carrying amount of the asset.

Operating Lease Equipment and FASB #121Operating Lease Equipment and FASB #121Accounting For the Impairment of LongAccounting For the Impairment of Long--lived lived

Assets and Assets to be DisposedAssets and Assets to be Disposed (continued)(continued)

"Measurement of Impairmentƒ Loss equal to the amount by which the carrying amount exceeds

the fair value of the asset.ƒ Report asset at new cost after impairment recognition.ƒ Restoration of previously recognized impairment losses is

prohibited."Fair Value Assessment

ƒ Current Sales Transactionƒ Present Value of expected future cash flows

"Assets to be Disposed Ofƒ Report Assets at lower of carrying amount or fair value, less cost to

sell.

Assumptions:Asset Carrying Value 5,000,000Monthly Lease Payment 80,000Residual Value 600,000Lease Term 60 MonthsDiscount Rate 8%

Operating Lease Writedown Operating Lease Writedown ExampleExample

AFTER YEAR 1Impairment Test:Cash Inflow: Rental Payments (80,000 X 48 Months) 3,840,000Residual Value 600,000Total Cash Inflow 4,440,000

Carrying Value 5,000,000Impairment Writedown Required (560,000)

Measurement of Impairment:PV of Lease Payments 3,713,105PV of Residual Value 436,152Total 4,149,257

Carrying Value 5,000,000Impairment (850,743)

SummarySummary

"Mechanics should be customized to fit your portfolio and resources.

ƒ High vs. Low Volume Portfolioƒ Automated vs. Manual Approach

"Trade-Offsƒ Efficiency vs. Precision

SummarySummary (continued)(continued)

"Benefits Derived From Reviewƒ Utilize results to aid in the pricing of new transactionsƒ Methods for reducing exposure may be identified

–Entice customers to enhance asset/extend lease–Enhance/ Develop Marketing Channels–Identify assets to sell

ƒ Gain Marketing's Support to Execute Ideas–Improved bottom line will bring support

"With proper planning and execution, review can be a powerful management tool.

End of Lease TransactionsEnd of Lease Transactions

"Lessee Returns the Equipmentƒ Reconditioning Costsƒ Inventory Valuationƒ Disposition of Inventory

"Lessee Purchases the Equipment

"Lessee Renews Lease for Specified Term

"Lessee Continues Monthly Payment (Continuation)

End of Lease Transactions:End of Lease Transactions:"Returned Equipment""Returned Equipment"

"Guidance - SFAS #13, Paragraph 17 F):ƒ A termination of the lease shall be accounted for by removing the net investment from the

accounts, recording the leased asset a the lower of its' original cost, present fair value, or present carrying amount, and the net adjustment will be charged to income of the period.

Capital OperatingDebit Credit Debit Credit

Min Lease Pmts 0 Equip. 500

UI 0 Acc. Depr. 400

RV 100

Inventory 90 Inventory 90

Fin Income 10 Depr. Exp. 10

Assumptions: RV=100 FMV=90

End of Lease Transactions:End of Lease Transactions:"Returned Equipment""Returned Equipment"(continued)(continued)

"Other possible charges for the net adjustment:ƒ Cost of Good Soldƒ Other (ex. Allowance for Doubtful Account or NIB)

"Segregate from other sources of inventoryƒ Propensity of Lessee Return vs. Purchaseƒ RV Accuracyƒ Future Profitability

End of Lease Transactions:End of Lease Transactions:"Returned Equipment""Returned Equipment"(continued)(continued)

Reconditioning CostsReconditioning Costs"Small dollars but very controllable"Low value parts & labor

ƒ Expense or Capitalize?ƒ Minimum Refurbishment vs. Value Add?ƒ Standard Cost or Actual Cost?ƒ Deciding Factors

–Materiality–Inventory Systems Capabilities–Cost Recovery / Profitability

"High Value Partsƒ Capitalize Costƒ If not purchased, cost may be assigned

–Relative FMV–List Price

End of Lease Transactions:End of Lease Transactions:"Returned Equipment""Returned Equipment"(continued)(continued)

Inventory ValuationInventory Valuation"Declines in FMV while in Inventory:

ƒ Should be recorded to cost of salesƒ Frequencyƒ Level of Precisionƒ Inventory Valuation vs. RV Reviews

–Parts or Whole Units–Better Availability of FMV Data

"FMV Listing is a useful tool for other areas:ƒ Comparison to Reconditioning Costsƒ Collateral Position of Lease Portfolioƒ Profit Potential of Current Inventoryƒ Planning & Pricing Use

End of Lease Transactions:End of Lease Transactions:"Returned Equipment""Returned Equipment"(continued)(continued)

Debit CreditA/R 110

Sales Revenue 110

COGS 90

Inventory 90

Disposition of Inventory Disposition of Inventory -- SaleSaleAssumptions: Retail FMV=110

"Sales are the only "Final" transaction, best time to check:ƒ Accuracy of RV Assumptionsƒ Profitability of Certain Offerings/Products

End of Lease Transactions:End of Lease Transactions:"Returned Equipment""Returned Equipment"(continued)(continued)

Disposition of Inventory Disposition of Inventory -- LeaseLease"Capital Lease from inventory are treated as sales type

ƒ Paragraph 6 B) of SFAS #13 defines sales type leases as "leases that give rise to manufacturer's or dealer's profit (or loss) to the lessor (i.e. the fair value of the leased property at the inception of the lease s greater than its cost or carrying amount, if different) and that they meet one or more of the criteria in paragraph 7 and both criteria in paragraph 8."

End of Lease Transactions:End of Lease Transactions:"Returned Equipment""Returned Equipment"(continued)(continued)

Sales Type OperatingDebit Credit Debit Credit

FMV- Rev from STL 110 Equip 90Min Lse Pmts 200 Acc Depr 0UI 100RV 10PV of RV-Rev 5PV of RV-Cost 5

Cost of STL 90Inventory 90 Inventory 90

"Important to measure profitability of leasesƒ Lease vs. Saleƒ Inventory Turn vs. Profitabilityƒ Data Integrityƒ Program of New Leases

"Assumptions: Retail FMV=110

End of Lease Transactions:End of Lease Transactions:"Equipment Purchased at EOL""Equipment Purchased at EOL"

"Assumptions: RV=100, Retail FMV=110

"Segregation from other channels of sales is desirableƒ Another measure of RV Accuracyƒ Strategic for "Inventory Avoidance

Capital OperatingDebit Credit Debit Credit

A/R 110 A/R 110

Sales Rev 110 Sales Rev 110

Min Lse Pmts 0

UI 0 Equip 500

RV 100 Acc Depr 400

COGS 100 COGS 100

End of Lease Transactions:End of Lease Transactions:"Lease Renewed at EOL""Lease Renewed at EOL"(continued)(continued)

Sales Type OperatingDebit Credit Debit Credit

FMV-Rev from STL 110 Equip(Old Lease) 500Min Lse Pmts 200 Acc Depr(Old Lease) 400UI 100 Equip(New Lease) 100RV(New Lease) 10 Acc Depr(New Lease) 0PV of RV-Rev 5PV of RV-Cost 5

Cost of STL 100RV(Old Lease) 100

"Similar entry & analysis as leased from inventory

"Capital Lease renewals upon EOL are treated as Sales Typeƒ Paragraph 9) of SFAS #13 "Any action that extends the lease beyond the expiration of the existing lease term, such as the exercise of a lease renewal option other than those already included in the lease term, shall be considered as a new agreement, which shall be classified according to the provisions of paragraphs 6-8."

"Assumptions: RV =100, Retail FMV=110

End of Lease Transactions:End of Lease Transactions:Existing Lease Payments are Cont.Existing Lease Payments are Cont.

"Expected term of this continuation is not always given"Materiality of these payments varies greatly"Due to month-to-month nature of commitment, continuations should be classified as operating leases"Billings can be booked as:

ƒ Rental Incomeƒ Credit to Residual Value

"Depreciation can be calculated using:ƒ End of Month estimated Residual Valueƒ Straight line over a standard renewal (or other) periodƒ Forced depreciation algorithm

End of Lease Transactions:End of Lease Transactions:SummarySummary

"No one right way to handle these transactions

"Great demand for data

"Can be used as a tool

"Accounting "Ownership" of results eliminates data disputes