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Flashcards in Ch 21 Deck (73):


Contractual agreement between lessor and lessee



Has right to use specific property for specified period of
Time under lease agreement

Makes rental payments of lease term to lessor



Owns property being leased


3 general categories of lessors that own property?

1 banks

2 captive leasing companies

3 independents


What 2 advantages to banks have with leasing?

1 have low cost funds which give them advantage of being
Able to purchase assets at less cost than competitors

2 leasing transactions are standardized, so banks don't need
To innovate to structure lease arrangements


Captive leasing companies

Subsidiaries whose primary business is performing leasing
Operations for parent company

Ex. IBM Global Financing, Ford Motor Credit


Advantage captive leasing companies have?

Point of sale advantage in finding leasing customers

Can quickly develop lease financing arrangement b/c has
Product knowledge that gives advantage when financing
Parent's product


Independents (lessors) what are they good at?

Developing innovative contracts for lessees


Independents (lessors), what are they starting to do?

Act as captive finance companies for some companies
That don't have leasing subsidiary


Leasing advantage: 100% financing at fixed rates

Signed without requiring any money Down for lessee
Helping lessee conserve scarce cash

Lease payments often remain fixed protecting lessee
Against inflation and increases in cost of money


Leasing advantage: protection against obsolescence (lessee)

Risk of obsolescence is reduced by leasing of lessee as
Risk of residual value is passed to lessor


Leasing advantage: protection against obsolescence (lessor)

Charges higher rent payments to lessee


Leasing advantage: flexibility

Duration of lease can be tailored as short term or span
The entire time for expected economic life of asset

Payment may be fixed or variable (pegged to interest rate
Or inflation), enabling lessor to recover cost of asset with fair


Lease term

Duration of lease


Leasing advantage: less costly financing

Claim tax benefits if in lower tax bracket (start up companies)


Leasing advantage: tax advantages

Synthetic lease arrangement allows companies to capitalize
And depreciate a leased asset for tax purposes

While keeping it off the balance sheet


Leasing advantage: off balance sheet financing

Keeping debt off balance sheet to not affect financial ratios
Adds to company's borrowing capacity


Executory contract

Requires continuing performance by both parties


4 views on capitalizing leases

1 don't capitalize any leased assets
2 capitalize leases that are similar to installment purchases
3 capitalize all long term leases
4 capitalize firm leases where penalty for nonperformance
Is substantial


Firm leases

Non cancelable contract, unlikely to avoid without severe


FASB: preferred lease capitalization approach

Capitalization approach when lease is similar to installment
Purchased and non cancelable

Capitalize a lease that transfers substantially all benefits
And risks of property ownership provided lease is noncancelable



Can only cancel lease contract only upon outcome of some
Remote contingency


How does a lessee capitalize a lease

Records asset and liability generally equal to present value
Of rental payments


In order to record a lease as a capital lease, the lease must...

Be noncancelable


4 capitalization criterial lessee

1 lease transfers ownership of property to lessee
2 lease contains bargain purchase option
3 lease term is equal to 75% or more of estimated economic
Life of property
4 present value of minimum lease payments (excluding
Executory costs) equals or exceeds 90 percent of fair
Value of leased property


Operating leases

Leases that do not meet any of the four criteria for


Bargain purchase option

Allows lessee to purchase leased property for price
significantly lower than property's expected FV at date
Option becomes exercisable


Bargain renewal option

Allows lessee to renew lease for rental that is lower than
expected fair rental at date option becomes exercisable


What 4 items do minimum lease payments include?

1 minimum rental payments
2 guaranteed residual value
3 penalty for failure to renew or extend lease
4 bargain purchase option


Residual value

Estimated fair value of leased property at end of lease term


Guaranteed residual value

Either determinable amount company will pay at end of
Lease to purchase asset

Or amount company/or 3rd party guarantees will be realized
When asset is returned


Third party guarantors

Insurers who for a fee assume risk of deficiencies in leased
Asset residual value


Unguaranteed residual value

Estimated residual value exclusive of any portion guaranteed


Executory costs for tangible assets

Incur insurance, maintenance and tax expenses during
Their economic life


Incremental borrowing rate

When is it not used?

Discount rate used to compute present value of minimum
lease payments

2) Not used when implicit rate of lessor is known


Leases: effective interest method

Used to allocate each lease payment btw/ interest and


For a capitalized asset and recorded obligation at present value, the depreciation of the asset and discharge of the obligation are...

Independent accounting processes


Operating method (lessee)

Rent expense (and associated liability) accrues day by day
To lessee as it uses the property

Lessee assigns rent to periods benefitting from use of
Asset and ignores (in accounting) commitments to make
Future payments


Disclosure of operating leases

Company must disclose all operating leases that have
Noncancelable lease terms in excess of 1 year


Why does the business community look negatively on capitalizing leases? 4 reasons

1 debt to equity increases
2 rate of return on total assets decreases
3 violation of loan covenants
4 affects compensation received by owners (ex. Stock
Compensation plan)


3 following differences occur if using capital lease instead of operating lease

1 increase in debt reported

2 increase in total assets (especially long lived assets)

3 lower income early in life of lease (therefore lower retained


3 advantages of leasing to the lessor?

1 interest revenue

2 tax incentives

3 high residual value


Leasing advantage for lessor: Interest revenue

Provides competitive interest margins


Leasing advantage for lessor: Tax incentives

Usually, Companies that lease can't use tax benefit of asset,
But leasing allows them to transfer tax benefits to another
Party (the lessor)

In exchange for a lower rental rate on leased asset


Leasing advantage for lessor: high residual value

Return of property at end of lease term, the more value
The higher the profit


3 classifications of leases by lessor

1 operating leases
2 direct financing leases
3 sales type leases


4 Capitalization criteria for lessor Group 1

1 lease transfers ownership of property to lessee
2 lease contains a bargain purchase option
3 lease term equal to 75% or more of economic life of leased
4 present value of minimum lease payments (excluding
Executory costs) equals or exceeds 90% fair value leased


2 Capitalization criteria (lessor) Group II

1 collectibility of payments required from lessee reasonably predictable

2 no key uncertainties surround amount of unreimbursable
Costs yet to be incurred by lessor under the lease


How many conditions under Group 1 and Group II or capitalization criteria requirements must be met for lessor to classify arrangement as direct financing lease or sales type lease?

Both criteria for group II and 1 or more criteria for group 1


Direct financing lease vs. sales type lease

Sales type lease involves manufacturer's or dealer's profit

Direct financing lease does not


Manufacturer's or dealer's profit (or loss)

Evidenced by difference between fair value of leased
Property at inception of lease and lessor's book value


The distinction for the lessor between a direct financing lease and a sales type lease is the presence or absence of...

A manufacturer's or dealer's profit (or loss)


Lessors classify and account for all leases that do not qualify as direct-financing or sales-type leases as...

Operating leases


Direct financing leases

Financing of an asset purchased by the lessee


Lease receivable (direct financing leases)

Lessor records "lease receivable" instead of leased asset


Operating method: rental receipts recorded by lessor

Recorded as rental revenue


6 lease arrangements that cause unique accounting problems

1 residual values
2 sales type leases (lessor)
3 bargain purchase options
4 initial direct costs
5 current vs. Noncurrent classification
6 disclosure


Guaranteed residual value

Lessee agrees to make up any deficiency below stated
Amount that lessor realizes in residual value at end of lease


3 sales type lease terms

1 lease receivable

2 sales price of the asset

3 cost of goods sold


Sales-type lease terms: lease receivable AKA net investment

Present value of minimum lease payments
+ PV of any Unguaranteed residual value


Sales-type lease term: Sales price of asset

Present value of minimum lease payment


Sales-type lease term: cost of goods sold

Cost of asset to lessor less PV of any Unguaranteed residual


Sales type lease: gross profit

Gross profit amount on sale of asset is same whether
Guaranteed or Unguaranteed residual value is involved


If the bargain purchase option exists the lessee must...

Increase the PV of minimum lease payments by the PV
Of the option price


Accounting treatment of computation of depreciation: bargain purchase option vs. guaranteed residual value

Guaranteed residual value: depreciates asset over lease term

Bargain purchase option: depreciates economic life of asset


2 types of initial direct costs (lessor)

1 incremental direct costs

2 internal direct costs


Incremental direct costs

Paid to independent third parties for orginating lease

Ex. Cost of independent appraisal of collateral used to secure lease, cost of outside credit check of lessee


Internal direct costs

Directly related to specified activities performed by lessor
On a given lease

Ex. Evaluating lessee's prospective financial condition,
Evaluating and recording guarantees and collateral


3 internal indirect costs (lessor performs)

1 advertising

2 servicing existing leases

3 establishing and monitoring credit policies


The most common method of measuring current liability portion in ordinary annuity leases?

Change in the present value method


How do companies get around capitalizing their leases ?

Companies design, write and interpret lease agreements
To prevent satisfying any if the 4 capitalized lease criteria


How do lessees and lessors get around the "90% recovery test"?
2 methods

1 use incremental borrowing rate by lessee when it is higher
Than implicit interest rate of lessor (making implicit int. rate
Unavailable to lessee)

2 residual value guarantees,


Residual value guarantees to get around 90% recovery test

Have 3rd party guarantee residual value, so minimum
Lease payments of lessee exclude the guarantee