Princess Regional Trucking Company has been approached by a client with an opportunity that would require 120 trailers which is about 20 more than we currently own. We are not sure how long the relationship with this customer will last but this deal has the potential for considerable growth. I have a great deal of information for you regarding lease options that Princess Regional Trucking Company may want to consider before going forward with this deal.
The first type of lease to consider is the direct financing lease. This lease is used by lessors in capital leases if the collections of minimum lease payments are guaranteed and the amounts of unrefundable costs are known in advance. In this type of lease the bank will buy new trucks and lease them to us instead of Princess Regional Trucking Company borrowing the money to purchase the trucks. The direct financing approach is the same as a loan. In order to arrange this type of lease we must show that the monthly payment will be met every month on time. This can be done by putting up assets to cover the payments just in case we cannot lease what is secured by the direct lease. Eliminating any question or doubt about the ability to cover the lease is the ultimate goal.
If you would prefer to go with the Capital lease option then it must meet one of the four criteria according to FASB ASC 840-10-25-1. There has to be a transfer of ownership to the lessee by the end of the lease term, the lease contains a bargain purchase option, the lease term is equal to 75% or more of the estimated economic life of the leased property, or the present value at the beginning of the lease term of the minimum lease payments, equals or exceeds 90% of the excess of the fair value of the leased property. If any of the four criteria is met and also meets both of these criteria’s in that the lease payments have to be reasonable and the costs to be incurred are also predictable the lease is considered to be either direct financing or sales-type (http://highered.mcgraw-hill.com/sites/dl/free/0073526878/588542/Codification_Updates.pdf)
The next type of lease to be addressed is a sales-type lease. Just like the capital lease there are for criteria that must be met. If the manufacture or dealer risks profit or loss then this would be a sales-type lease. This would mean that the seller would keep the assets in their inventory while the manufacturer or dealer are still earning profit or taking a loss. Under FASB ASC 840-30-35-22 the lessor must amortize the unearned income on a sales-type lease to income over the lease term to produce a constant periodic rate of return on the net investment in the lease.(http://highered.mcgraw-hill.com/sites/dl/free/0073526878/588542/Codification_Updates.pdf)
Since the important part of a sales-type lease is the sale the initial direct costs of getting the lease is written off when the sale is recorded at the beginning of the lease. This would be noted on the income statement as a selling expense.
The final type of lease option would be an operating lease. This type of lease allows use of an asset but does not transfer ownership of the asset. The assets are expected to be returned at the end of the lease agreement. This lease would give Princess the sole right to use the asset however the lessee would retain all risks and rewards of ownership. It would be shown as a rental expense on the balance sheet. It is considered an asset for us and gets depreciated like any other asset. This type of lease is usually short term but it can be cancelled if needed.
Thank you for taking the time to review these three different types of leases for the additional trucks we need to satisfy our new customer. Since we are not certain the time frame of this relationship I would like to suggest going with the operating lease since it is more like a rental agreement.