Minimum Lease Payment

Minimum Lease Payment — Definition and Calculation

Minimum lease payments are the lowest total payments a lessee is contractually required to make over the life of a lease. Accountants discount these payments to present value to determine the lease’s value for financial reporting and to help decide lease classification.

What’s included and excluded

• Included:
• Scheduled rental payments over the lease term
• Amounts payable under a bargain purchase option
• Any guaranteed residual value (amount the lessee or a third party guarantees the lessor will realize)
• Payments required for non‑renewal or other contractual minimums
• Excluded:
• Executory costs the lessor is expected to pay (e.g., maintenance, insurance)
• Contingent rentals (payments that depend on future events, unless they are minimums)

Why it matters

Minimum lease payments are used in the “recovery of investment” (90%) test to determine whether a lease should be recorded as a finance (capital) lease or as an operating lease. If the present value (PV) of minimum lease payments is equal to or greater than 90% of the fair value of the leased asset, the lease is typically classified as a finance lease.

Present Value Formula

Compute the present value of the minimum lease payments using:

PV = Σ (Pmt_i / (1 + r)^i) + Res / (1 + r)^n

where:
– PV = present value of the minimum lease payments
– Pmt_i = lease payment in period i
– r = discount rate per period (use the appropriate rate for the lease term)
– n = number of payment periods
– Res = residual amount guaranteed or expected at the end of the lease

Note: If payments are monthly, convert the annual rate to a monthly rate and use monthly periods.

Example

A company leases trucks for 3 years. Payments are $3,000 per month = $36,000 per year. The annual discount rate is 5%. Residual value at lease end = $45,000.

Using annual periods for simplicity:

PV = 36,000/1.05^1 + 36,000/1.05^2 + 36,000/1.05^3 + 45,000/1.05^3
PV = 34,285.71 + 32,653.06 + 31,098.83 + 38,873.53 = $136,911.13

In today’s dollars, the lease’s minimum payments are worth $136,911.13.

Key Takeaways

• Minimum lease payments form the basis for valuing a lease for accounting purposes.
• Calculate PV by discounting scheduled payments and any guaranteed residual value.
• Include bargain purchase options and guaranteed residuals; exclude executory costs and contingent rentals (unless they are minimum obligations).
• Use the PV result for lease classification and to record the lease on financial statements.