lease v buy

what is a lease?

long-term rental agreement

lessor

A party that has agreed contractually to let another party use its asset for a period at an agreed price (landlord, owner)

lessee

A party that has made contractual arrangements to use another party's asset for a period at an agreed price (user, tenant).

operating lease

short-term lease, often cancelable; when lease is up, you give the asset back to the lessor and the lessor bears all the risk that when you return the asset, the market value has tanked (residual value)

- lessor maintains and insures the assets (e.g. calling landlord when toilet breaks in apartment)

- historically not amortized at all, not on balance sheet, no pricing

financial (capital) lease

long-term lease, non-cancellable (lessee makes all payments or faces bankruptcy), lease payments make up most of the value, e.g. automobile lease

- fully amortized: as you make lease payments, the value goes down. appears on balance sheet

- no maintenance or service provided

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

- to price, we take the PV of the lease payment, that's the book value

liability

operating lease is always a ___________

both a liability and asset

capital (financial) lease can be ___________

- uses the same name on both sides of the balance sheet

right of use asset

gives you a right to use the asset that you paid for

why have operating leases not been fully amortized?

the payments under the lease are not enough to recover the full cost of the asset bc the term of the lease is substantially less than the life of the asset

- Only part of the asset's cost is covered by your payments

- There's still remaining value left at the end

- the lessor has to recover the remaining value by either renewing the lease or selling the asset

residual risk

The lessor is taking the risk on what the asset will be worth later

financial lease reporting

- Balance sheet: record both right of use asset, and lease liability (= PV of lease payments)

- Income statement: record both depreciation expense (from ROU) and interest expense (from lease liability)

5 criteria for financial leases

1. transfer ownership to lessee

2. purchase option: can buy at a cheap price later

3. Lease term ≥ ~75% of asset life (e.g. if asset life is 10 years and your lease is 8 years)

4. PV of payments ≥ ~90% of value (you basically paid for the whole thing)

5. Asset is too specialized, and the lessor cannot use it after the lease period is up

ASC 840

With operating leases: the company HAD a real obligation to make payments, but it was not shown on the balance sheet

- looked like no debt existed

- rent expense recognized on inc stmt but nothing on balance sheet

- Look less leveraged than they actually were

ASC 842

Now, all leases are on the balance sheet (capitalized)

- You record BOTH: Right-of-Use (ROU) Asset & Lease Liability (PV of payments)

- if lease has maturity of ,< 12 months, it doesn't have to be capitalized

lease benefits

- conserves cash: don't have to spend a large amount upfront

- 100% financing, no down payment

- protects working capital (cash for day to day operations)

- keeps credit lines available and can be used later for other credit needs

- Operating lease payments are fully deductible for tax purposes

- align expenses with the income the asset generates (e.g. 3 year project, 3 year lease)

- reduces life-cycle costs, cuts through red tape, avoid tech obsolescence