- A contractual agreement between a lessor and a lessee
- lessee makes rental payments and has the right to use specific property for a specified amt of time, frm lessor
Who r lessor?
- 1) Banks
- 2) Captive leasing companies- subsidiaries...they perform the leasing operations for parent comp.
- 3) Independents- give innovative contracts for lessee
Advantages of Leasing
- 1) 100% financing at fixed rate- no $ down, don't deal with inflation costs.
- 2) Protection against obsolescence- trade in old equip for new.
- 3) Flexibility - % rate, payments (level or up and down)
- 4) Less Costly - both can take advantage of leasing tax benefits = less rental payments/$ back otherwise wouldn't be realized.
- 5) Tax Advantage -
- 6) Off-Balance-Sheet Financing -
can be short period of time to entire expected economic life of the asset
Tax Advantage. What do companies do for financial and tax reporting? and what results from it?
- Financial Report- do not report an asset/liability
- Tax Purposes- can capitalize n depreciate the leased asset
- = tax deductions early --> reduce taxes.
- Means to record the amt of an item in a balance sheet account as opposed to the income statement.
- Ex: Forklift truck should appear on the balance sheet as part of the company's equipment, and the amt of principal owed needs to be reported as a liability on the balance sheet.
- Balance Sheet- Equipment n liability (principle owed)
CERTAIN leases do not add to debt or affect financial ratios on Balance Sheet. It may add to borrowing capacity.
Capitalization of leases- FASB agrees with which approach?
- Capitalize when the lease is similar to an installment plan.
- Should capitalize a lease that transfers substantially all of the benefits and risks of property ownership, provided the lease is noncancelable.
cant cancel unless there is some remote contingency. or company wont cancel cuz provisions and penalties are too costly.
To report a lease --> 3 conclusions
- 1) Companies must identify the characteristics that indicate the transfer of substantially all of the benefits and risks of ownership
- 2) The same characteristics should apply consistently to the lessee and the lessor
- 3) Those leases that do NOT transfer substantially all the benefits and risks of ownership are operating leases. (Companies should NOT capitalize operating leases, they should account for them as rental payments and receipts.)
Must be noncancelable & meet 1 or more of the 4 capitalization Criteria for lessee.
Lessee- Capitalization Criteria
- 1) Lease transfers ownership of the property to the lessee
- 2) The lease contains a bargain-purchase option
- 3) The lease term is equal to 75% or more of the est. economic life of the leased property
- 4) The Present Value for the min lease payments (excluding executory costs) equals or exceeds 90% of the fair value of the leased property)
leases that do NOT transfer substantially all the benefits and risks of ownership
Lessee classify accounts that do not meet any of the 4 criteria as ______
Allows lessee to purchase the leased property for a price that is significantly lower than the property's expected fair value at the date the option becomes exercisable.
Allows the lessee to renew the lease for a rental that is lower than the expected fair rental at the date the option becomes exercisable.
Why should a lessee capitalize leased asset if PV of min lease payments equals or exceeds 90%?
Cuz PV of min. lease payments is reasonably close to the mkt price --> basically it is effectively purchasing the asset.
is the est. fair (mkt) value of the leased property at the end of the lease term
Guaranteed residual value
- - the certain or determinable amt lessee will pay lessor @ the end of the lease to purchase
- -Amt lessee or the 3rd party guarantees lessor will realize if the asset is returned
Leased assets that incur insurance, maintenance & tax expenses
Depreciation for a Capital and Operating lease
- Captial- depreciate using the economic life of the asset
- Operating- depreciate it over the term of the lease
A series of equal amounts occurring at the beginning of each equal time interval.
Executory Costs are considered "________", therefore________________.
Ownership-type costs, therefore it is not included in PV of min lease payments. Must exclude executory costs in computing costs (lessor) n making payments (lessee)
Depreciation - Straight Line Method
The depreciation method that results in the same equal amount of depreciation expense for each full year over the life of the asset.
How to compute capitalized lease payments
Monthly payments - executory costs X PV of an annuity due @ rate %
Operating Lease Method (Lessee)
- Expense & Liability
- Lessee assigns rent to the periods benefiting from the use of the asset and ignores, in the accounting , any commitments to make future payments
Operating Method- what is or is not reported on the B/S and Income Statement?
- B/S - Do not report equip / long term liab. for future rental payments
- I/S - Report Expense
Capital vs Operating Lease charges. What is the same and what is different when it comes to charges?
- Same- Total charges to operations are the same over the lease term
- Dif - Capital charges are higher in earlier years n lower in later years.
Why are companies reluctant to use capital leases?
- 1) increase amt of reported debt (debt to equity is high)
- 2) increase in the amt of total assets
- 3) Lower income at beg. of lease --> lower retained earnings
- less attractive to investors
Lease benefits to a Lessor
- 1) % Revenue
- 2) Tax Incentives- can lead to lower rental payments. Ex: boeing sold an airplane, wealthy investor bought only to use as a tax benefit, then sold to a foreign company at a cheaper price. (everyone wins!)
- 3) High residual Values- the return of the property at the end of the lease term can produce profits.
An implicit interest rate is one that is not explicit; in other words, the rate is not stated. For example, if I lend you $5,000 and you agree to repay me $1,000 at the end of each year for six years you are obviously paying interest. However, our agreement did not specify any interest or interest rate. To find the interest rate that is “implicit” in this arrangement, you would do a present value calculation via a financial calculator, software, or present value tables.
Lessor can classify leases in these categories
- 1) Operating leases
- 2) Direct-financing Leases
- 3) Sales-type leases
For a lessor to classify a leases as a direct-financing / Sales-type leases it must meet these criteria's
- 1) must meet 1 or more in Grp 1 (same as lessee list)
- 2) must meet both criteria in Grp 2
Lessor- difference btwn direct-financing and Sales-Type Lease
- is the presence / absence of a manufacturer's or dealer's profit (loss)
- Profit (loss)- difference btwn the fair value of the leased property at the inception of the lease and the lessor's cost or carrying amt (book value)
If the lease does not meet any of Grp one criteria for lessor it is categorized as a ________ lease.
If collectibility of lease payments are not reasonably certain then it is considered a ______ lease.
If the Lessor's performance is not substantially complete then the lease is considered a(n) _________ lease.
If a lease agreement meets 1 criteria in grp 1 & both in grp 2, but the asset fair value is not equal to lessor's book value, then it is considered a _____ lease.
If a lease agreement meets 1 criteria in grp 1 & both in grp 2 and the asset fair value is equal to lessor's book value, then it is considered a _____ lease.
Sales-Type Lease (Lessor)
involves a profit (loss). it is the difference btwn the fair value at the time of lease inception & the lessor's cost (book value)
the financing of an asset purchase by the lessee
Lessor records a receivable while the lessee records a lease Asset. And a lease receivable is the PV of min lease payments.
Min. Lease Payments include the following:
- 1) Rental Payments (minus executory costs)
- 2) Bargain-purchase option (if any)
- 3) Guaranteed residual value (if any)
- 4) Penalty for failure to renew (if any)