Modelling Finance Leases - Financial Steps

Finance lease modeling involves forecasting the financial impact of leasing an asset rather than purchasing it outright. It’s crucial for assessing whether a lease is beneficial compared to a loan-financed purchase and for fulfilling accounting requirements. The model focuses on projecting cash flows and their present values. At the core of the model is a schedule of lease payments. These payments are typically fixed, but the model should accommodate variable payments indexed to inflation or other benchmarks. The schedule includes the payment amount, payment date, and allocation between principal (reducing the lease liability) and interest (expense). The implicit interest rate (or discount rate) embedded in the lease is a critical input. This rate can often be determined by matching the present value of the lease payments to the fair value of the leased asset. If the rate is not explicitly stated, an iterative process may be required to solve for it. The model should then incorporate depreciation. Since the lessee effectively controls the asset during the lease term, they depreciate it as if it were owned. The depreciation method (e.g., straight-line, declining balance) should align with the lessee’s existing accounting policies for similar assets. The depreciable base is usually the lower of the asset’s fair value at the lease inception or the present value of the minimum lease payments. Tax implications are also important. Lease payments are typically tax-deductible expenses, while depreciation generates a tax shield. The model should factor in the lessee’s effective tax rate to calculate the after-tax cost of the lease. If the lease contains a bargain purchase option (allowing the lessee to buy the asset at a significantly discounted price at the end of the lease term), the model needs to consider the potential impact on future cash flows and tax liabilities. To compare the lease to a purchase, the model also needs to simulate the loan alternative. This involves calculating loan payments based on a market interest rate, projecting depreciation on the purchased asset, and factoring in tax benefits. The model then calculates the net present value (NPV) of the lease and the purchase options, using the lessee’s cost of capital as the discount rate. A lower NPV generally indicates the more favorable option. Sensitivity analysis is crucial. The model should allow for varying key inputs like the discount rate, lease payment amounts, useful life of the asset, and tax rate to assess the robustness of the results. Scenario planning, where different economic environments are simulated, can also provide valuable insights. Finally, the model should generate relevant accounting entries, including the initial recognition of the lease asset and liability, subsequent amortization of the asset and liability, and interest expense recognition. These entries are essential for preparing accurate financial statements and complying with lease accounting standards like ASC 842 or IFRS 16. This information allows stakeholders to understand the impact of the lease on the company’s balance sheet and income statement.