What Are Minimum Lease Payments?
The minimum lease payment is the lowest amount that a lessor can expect to earn (and a lessee can expect to pay) over the lifetime of a lease agreement. Accountants calculate minimum lease payments to assign a present value to a lease, which is essential for accurate financial recording in a company’s books. This process is governed by standardized accounting principles.
Key Takeaways
- Minimum lease payments refer to the lowest anticipated amount a lessee is expected to pay over the course of a leased asset or property.
- Present value calculations are used to discount future lease payments to account for the time value of money accurately.
- Minimum lease payment estimates use a 90% test for an asset’s recovery of investment, regardless of whether it is categorized as a capital or operating lease.
The Formula for Minimum Lease Payments and Lease Valuation
The present value (PV) formula includes the minimum lease payments and the total value of the lease. Leased assets often have a residual value at the end of the lease term, which represents the estimated remaining value of the asset.
1PV = Σᵢ=₀ⁿ [ Pmti / (1+r)ⁱ ] + Res / (1+r)ⁿ
2where:
3PV = Present value of the minimum lease payments
4Pmti = Lease payment for period i
5r = Interest rate
6n = Number of payment periods
7Res = Residual amount
What Does Calculating Minimum Lease Payments Tell You?
The calculation of minimum lease payments is crucial in conducting a recovery of investment test (90% test). This test decides if a lease should be documented as an operating lease or a capital lease. Accounting treatments vary depending on whether the entity is the lessor or the lessee.
When companies are unable to purchase equipment outright or anticipate a short useful life for the equipment, they may opt to lease it. Consequently, the lessor retains ownership and the lessee makes regular payments for its use. The minimum payment stipulated in the lease agreement is what we refer to as the minimum lease payment.
Minimum lease payments encompass regular payments over the lease term, including any bargain purchase options, rental premiums, guaranteed residual values, but excluding lessor costs such as maintenance and contingent rentals.
Special Considerations
Although a straightforward 12-month lease at $1,000 a month suggests minimum payments of $12,000, additional contractual clauses can complicate this figure. Costs like maintenance and insurance are typically excluded as they fall under the lessor’s responsibilities. However, guarantees on residual values and non-renewal payments can affect the lease cost.
By factoring in all applicable components, a present value can be assigned for accounting purposes.
Example of Minimum Lease Payments and Present Value
Let’s illustrate with an example. Suppose a company enters into a 3-year lease for heavy-duty trucks at $3,000 per month ($36,000 per year) with an annual interest rate of 5% (or approximately 0.417% per month).
The lease’s residual value after three years is projected to be $45,000. To find the present value (PV) of the lease, we calculate as follows:
1PV = ($36,000 / 1.05¹) + ($36,000 / 1.05²) + ($36,000 / 1.05³) + ($45,000 / 1.05³)
2 = $34,285.71 + $32,653.06 + $31,098.83 + $38,873.53
3 = $136,911.13
Therefore, the lease will be valued at approximately $136,911.13 in today’s dollars.
Related Terms: capital lease, operating lease, present value, residual value, discount rate.
