Ch 21 - Leases Flashcards
(40 cards)
What are the 4 advantages leasing can provide for the lessee?
- 100% financing at fixed rates.
- Protection against obsolescence.
- Flexibility.
- Less costly financing.
Leasing advantage for lessee:
100% financing at fixed rates:
Leases are often signed without requiring any money down from the lessee. This helps the lessee conserve scarce cash—an especially desirable feature for new and developing companies. In addition, lease payments often remain fixed, which protects the lessee against inflation and increases in the cost of money. The following comment explains why companies choose a lease instead of a conventional loan: “Our local bank finally came up to 80 percent of the purchase price but wouldn’t go any higher, and they wanted a floating interest rate. We just couldn’t afford the down payment, and we needed to lock in a final payment rate we knew we could live with.”
Leasing advantage for lessee:
Protection against obsolescence:
Leasing equipment reduces risk of obsolescence to the lessee and in many cases passes the risk of residual value to the lessor. For example, Merck (a pharmaceutical maker) leases computers. Under the lease agreement, Merck may turn in an old computer for a new model at any time, canceling the old lease and writing a new one. The lessor adds the cost of the new lease to the balance due on the old lease, less the old computer’s trade-in value. As one treasurer remarked, “Our instinct is to purchase.” But if a new computer is likely to come along in a short time, “then leasing is just a heck of a lot more convenient than purchasing.” Naturally, the lessor also protects itself by requiring the lessee to pay higher rental payments or provide additional payments if the lessee does not maintain the asset.
Leasing advantage for lessee:
Flexibility:
Lease agreements may contain less restrictive provisions than other debt agreements. Innovative lessors can tailor a lease agreement to the lessee’s special needs. For instance, the duration of the lease—the lease term—may be anything from a short period of time to the entire expected economic life of the asset. The rental payments may be level from year to year, or they may increase or decrease in amount. The payment amount may be predetermined or may vary with sales, the prime interest rate, the Consumer Price Index, or some other factor. In most cases, the rent is set to enable the lessor to recover the cost of the asset plus a fair return over the life of the lease.
Leasing advantage for lessee:
Less costly financing:
Some companies find leasing cheaper than other forms of financing. For example, start-up companies in depressed industries or companies in low tax brackets may lease to claim tax benefits that they might otherwise lose. Depreciation deductions offer no benefit to companies that have little if any taxable income. Through leasing, the leasing companies or financial institutions use these tax benefits. They can then pass some of these tax benefits back to the user of the asset in the form of lower rental payments.
What categories do lessors generally fall into?
- Banks
- Captive leasing companies
- Independents
Lessors:
Banks:
Banks are the largest players in the leasing business. They have low-cost funds, which give them the advantage of being able to purchase assets at less cost than their competitors. Banks have been aggressive in the leasing markets. Deciding that there is money to be made in leasing, banks have expanded their product lines in this area. Finally, leasing transactions are now quite standardized, which gives banks an advantage because they do not have to be as innovative in structuring lease arrangements. Thus, banks like Wells Fargo, Chase, Citigroup, and PNC have substantial leasing subsidiaries.
Lessors:
Captive Leasing Companies:
Captive leasing companies are subsidiaries whose primary business is to perform leasing operations for the parent company. Companies like Caterpillar Financial Services Corp. (for Caterpillar), Ford Motor Credit (for Ford), and IBM Global Financing (for IBM) facilitate the sale of products to consumers. For example, suppose that Sterling Construction Co. wants to acquire a number of earthmovers from Caterpillar. In this case, Caterpillar Financial Services Corp. will offer to structure the transaction as a lease rather than as a purchase. Thus, Caterpillar Financial provides the financing rather than an outside financial institution.
Captive leasing companies have the point-of-sale advantage in finding leasing customers. That is, as soon as Caterpillar receives a possible equipment order, its leasing subsidiary can quickly develop a lease-financing arrangement. Furthermore, the captive lessor has product knowledge that gives it an advantage when financing the parent’s product. The current trend is for captives to focus primarily on their companies’ products rather than execute general lease financing. For example, Boeing Capital and UPS Capital are two captives that have left the general finance business to focus exclusively on their parent companies’ products.
Lessors:
Independents:
Independents are the final category of lessors. Their market share has dropped fairly dramatically as banks and captive leasing companies have become more aggressive in the lease-financing area. Independents do not have point-of-sale access, nor do they have a low cost of funds advantage. What they are often good at is developing innovative contracts for lessees. In addition, they are starting to act as captive finance companies for some companies that do not have leasing subsidiaries. For example, International Lease Finance Corp. is one of the world’s largest independent lessors. According to recent data from the Equipment Leasing and Finance Foundation 2015 Annual Report on new business volume by lessor type, banks hold about 55 percent of the market, followed by captives at 31 percent. Independents had the remaining 14 percent of new business.
What are the 4 advantages leasing can provide for the lessor?
- Profitable interest margins
- Stimulate sales
- Tax benefits
- –Boeing Aircraft might sell one of its 737 jet planes to a wealthy investor who does not need a plane but could use the tax benefit. The investor (the lessor) then leases the plane to a foreign airline, for which the tax benefit is of no use. Everyone gains. Boeing sells its airplane, the investor receives the tax benefit, and the foreign airline receives a lower rental rate because the lessor is able to use the tax benefit - High residual value to the lessor upon the return of the property at the end of the lease term
Which approach of capitalizing leases has the FASB recently adopted?
Capitalize all long-term leases.
This approach requires only the long-term right to use the property in order to capitalize. This property-rights approach capitalizes all long-term leases.
The only exception to capitalization is that leases covering a term of less than one year do not have to be capitalized.
What does it mean to capitalize on a lease?
The lessee creates an asset account for the leased item, and the asset value on the balance sheet is the lesser of the fair market value or the present value of the lease payments. The lessee also posts a lease obligation in the liability section of the balance sheet for the same dollar amount as the asset. Over time, the leased asset is depreciated and the book value declines.
Companies classify lease arrangements as either:
finance or operating
The balance sheet for a company that uses either a finance lease or an operating lease will be
A.) The same
B.) Different
C.) It depends
A.) The same
For a finance lease:
the lessee recognizes interest expense on the lease liability over the life of the lease using the effective-interest method and records amortization expense on the right-of-use asset generally on a straight-line basis.
A lessee, therefore, reports both interest expense and amortization of the right-of-use asset on the income statement. As a result, the total expense for the lease transaction is generally higher in the earlier years of the lease arrangement under a finance lease arrangement.
In an operating lease:
the lessee also measures interest expense using the effective-interest method. However, the lessee amortizes the right-of-use asset such that the total reported lease expense is the same from period to period. In other words, for operating leases, only a single lease expense (comprised of interest on the liability and amortization of the right-of-use asset) is recognized on the income statement, typically on a straight-line basis. Illustrations of both these approaches are shown in the following sections.
If the lease transfers control (or ownership) of the underlying asset to a lessee, then the lease is classified as
A.) A finance lease
B.) An operating lease
A.) A finance lease
The lessee takes ownership or consumes a substantial portion of the underlying asset over the lease term.
All leases that do not meet any of the finance lease tests are classified as operating leases.
In an operating lease, a lessee:
obtains the right to use the underlying asset but not ownership of the asset itself.
Ex. A lease may convey the use of one floor of an office building for five years. At the end of the lease, the lessee vacates the floor and the lessor can then lease the floor to another tenant. So this lease (an operating lease) conveys right-of-use but not ownership; the lessee controls the leased asset only during the five-year lease.
For a lease to be a finance lease, it must:
be non-cancelable and meet at least one of the five lease classification tests.
Transfer of Ownership Test:
If the lease transfers ownership of the asset to the lessee, it is a finance lease.
Purchase Option Test:
A purchase option test is met if it is reasonably certain that the lessee will exercise the option. In other words, the lease purchase option allows the lessee to purchase the property for a price that is significantly lower than the underlying asset’s expected fair value at the date the option becomes exercisable (hereafter referred to as a bargain purchase option).
For example, assume that Brett’s Delivery Service leases a Honda Accord for $499 per month for 40 months, with an option to purchase the Accord for $100 at that end of the lease. If the estimated fair value of the Honda Accord is $3,000 at the end of the 40 months, the $100 option is clearly a bargain purchase option. Therefore, Brett’s accounts for this lease as a finance lease.
What is a bargain renewal option?
An option in the lease term test that allows the lessee to renew the lease for a rental that is lower than the expected fair rental at the time the option becomes exercisable.
At the commencement of the lease, the difference between the renewal rental and the expected fair rental must be great enough to make exercise of the option to renew reasonably certain. Thus, companies should include in the lease term any bargain renewal periods.
Ex. assume that Home Depot leases Dell PCs for two years at a rental of $100 per month per computer. In addition, Home Depot can lease these computers for $10 per month per computer for another two years. The lease clearly offers a bargain renewal option, and Home Depot should consider the lease term for these computers to be four years, not two.
Present Value Test:
If the present value of the lease payments is reasonably close to the fair value of the asset, a company is effectively purchasing the asset and should therefore use the finance method to account for the lease.
— 90% Test —
If the present value of the lease payments equals or exceeds 90 percent of the fair value of the asset, then a lessee should use the finance method to record the lease.
To apply the present value test, a lessee must determine the amount of lease payments and the appropriate discount rate.
Lease Term Test:
When the lease term is a major part of the remaining economic life of the leased asset, companies should use the finance method in accounting for the lease transaction.
— 75% Test —
If the lease term is 75 percent or greater of the economic life of the leased asset, the lease meets the lease term test, and finance lease treatment is appropriate.
