Leasing

What is a lease?

• A lease is an extended rental agreement

• The owner of the equipment is the lessor

• The user is the lessee

• A rental agreement

• Can also rent labor

• The lessor allows the lessee to use the asset (or property) in exchange for regular lease payments

• The lessee is not all that concerned about who owns the lease, what they care about is the use of the asset

• A lease is annuity due so payment is at the beginning of the period

Different types of leases

• Operating Leases

• Capital / Financing Leases

Operating Leases

Short-term lease

• Years ago, the lessee received an operator along with the leased equipment; hence, the name operating lease

• Historically, operating leases

  • have not been fully amortized

  • The payments under the lease are not enough to recover the full cost of the asset. This is because the term of the lease is substantially less than the life of the asset.

So when the lease is up,

• The lessor must recover the residual value by either renewing the lease or by selling the asset

• The lessor retains the residual risk

two big risks to the lessor

• counterparty risk that they will not pay it / credit risk

• residual value / risk

• the lessor hopes that it is worth more than it is supposed to be

Who maintains the asset?

• Very often, the LESSOR is responsible for maintaining and insuring the leased asset

• Example: Leasing an apartment

Operating leases are…

• CANCELABLE!

• Value of the cancellation clause depends upon future technological or economic conditions

• have to pay a penalty based on the liquidity

Capital / Financial Leases

• Long-term leases

• Different from operating leases

• Still annuity due

• Are fully amortized - recent development

• No maintenance or service is provided

• good for a market that is quickly developing and the current products become obsolete quickly

Example: Automobile lease

• are fully amortized

• no maintenance or service is provided

• lessee usually has the right of first refusal to renew the lease upon expiration

• They cannot be cancelled. The lessee must either make all the payments or face bankruptcy.

Lease Accounting: ASC 840 vs ASC 842

Firms had an incentive to keep leasing “off the books” which led to confusion

• they did not have a matching asset - a right to use asset - so that they could

Capital leases are now called Financial Leases

no change in the way we account for them

Financial Leases

• the leased asset must be reported as an asset

• the preset value of the lease payments must be reported as a liability

• looks identical to debt financing

Financial leases are similar to purchases, so

• they have traditionally been capitalized

• the firm can deduct depreciation and interest expense on the lease

• But … remember, they have to record the assets and liabilities

five criteria for financial leases - don’t need to memorize these

• transference of title / ownership to the lessee

• purchase option

• lease term for major part of the remaining economic life (> 75%) of the asset

• present value represents “substantially all” of the fair value (>90%) of the asset

• asset is too specialized, and the lessor cannot use it after the lease period is up

if an asset doesn’t meet these criteria, then it is automatically an operating lease

Operating Lease - ASC 840 - the old days

• the firm has the liability to pay back the lease

• But, the liability was hidden. It did not appear on the balance sheet either.

Operating Lease - ASC 842 - from now on

• All leases are reported on balance sheet

• Requires recognition of a right of use (ROU) asset and a corresponding operating lease liability, just like a financial lease

• All leases are capitalized

ASC 840 vs ASC 842

• ASC 840

  • Operating Leases are off-balance sheet

  • The expense associated with the lease was recognized in the income statement, but there was not any balance sheet impact

• ASC 842

  • All leases are reported on balance sheet

  • Requires recognition of a right of use (ROU) asset and a corresponding lease liability upon lease commencement

Not all operating leases have to be capitalized

• Those with a maturity of <12 months

• Those that do not meet the capitalization threshold in terms of dollars

• Firm believes that leases below this capitalization value are not material to the company and are therefore not recognized

depreciation tax benefit calculation for lease and buy

lease tax benefit = lease payment amount * tax rate

buy tax benefit = annual depreciation * tax rate

Intuition

• the client must decide whether to pay the purchase price for the equipment and enjoy the depreciation tax shield

  OR

• invest the purchase price somewhere else and write off the lease payments

What does leasing have to offer your customers that buying does not?

Leasing conserves capital

• Leasing can ease the strain on working capital by providing 100 percent financing without a down payment

• No money down

• Plus, an added benefit is that existing lines of credit remain intact for other credit needs

Leasing has tax benefits

• Operating lease payments are fully deductible for tax purposes. You write them off

• Leasing also allows you to match the cost of equipment utilization with the cash flows derived from contract or limited term jobs or projects. Only pay for what you use

Leasing reduces life-cycle costs

• the lessor adopts the residual risk at the end of term

• the lessee does not have any responsibility to recover the residual value at the end of term

• So who cares if the price drops in the future? That’s the lessor’s problem

Leasing cuts through red tape

• Operating leases mean no new ASSETS

• So, clients either avoid or minimize capital budget appropriation / approval delays

• Generally, since lease payments are operating expenses, they are accounted for in an organization’s operating budget, NOT capital budget

• So the firm doesn’t have to work through a time-consuming capital expenditure approval process

Customers avoid technology obsolescence

• As businesses grow or technology changes, additional or upgraded equipment will be required

• With leasing, a lessee can add or upgrade equipment at any point during the lease term