Ch 21 Flashcards
Lessee
Has right to use specific property for specified period of
Time under lease agreement
Makes rental payments of lease term to lessor
Lease
Contractual agreement between lessor and lessee
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
Return
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
Penalty
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
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
capitalization
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
Principal
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
Earnings)
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
Property
4 present value of minimum lease payments (excluding
Executory costs) equals or exceeds 90% fair value leased
Property
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
Term
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
Value
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
Arrangement
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
