leasing Flashcards
lessor and lessee
lease agreement
the party who owns that asset
the party using the asset- pays lease rentals to the lessor over a period of time
leasing allows a company to
use an asset without owning it
features of lease
- Most leases involve little or no upfront payment.
- The lessee commits to make regular lease payments for the term of the contract.
- At the end of the contract term, the lease specifies who will retain ownership of the asset and at what terms.
when are lease payments typically made?
at the beginning of each payment period
what are the 2 basic types of leases
- operating leases
- financial eases
what does operating lease separate?
Operating leases separate the risks of ownership from the use of the leased asset
advantages of operating leases
- lower transaction costs
- convenience and flexibility,
- isurance against the risk of obsolescence.
describe the risk of ownership of financial leaes
the risks of ownership are borne by the user of the asset
financial leases
describe leasing of expensive assets and general use assets
Leasing of very expensive assets is driven by tax-related factors.
Except where there are significant tax advantages, leasing of specialised assets is much less common than leasing of general use or marketable assets, such as motor vehicles and computers.
lease payment formula
PV(lease payments) = purchase price - PV (residual value)
Sales-type lease?
the lessor is the manufacturer (or primary dealer) of the asset
nDirect Lease
¡A type of lease in which the lessor is not the manufacturer, but is often an independent company that specializes in purchasing assets and leasing them to customers
describe sale and lease-back
- owner sells an asset (usually at current market value)
- receives cash from sale of asset
- leases it back by making lease payments to use the asset
who is the lessor usually in a sale and lease-back agreement?
aninsurance company, although some superannuation funds, banks and specialist leasing companies also offer this form of finance.
leveraged leasing is a form of?
Leveraged leasing, which is a form of finance lease
describes levered lease
when lessor borrows from a lender (debt participant) to obtain the initial capital to purchase the asset, using lease payments to pay interest and principal on the loan
leveraged leasing
how much does the debt participant lend?
the debt participants are expected to contribute no more than 80 per cent of the cost of the asset.
leveraged leasing
who are the debt participants usually?
a life insurance company, superannuation fund, investment bank or bank.
the loan provided by the debt participant is a non-recourse loan. what does this mean
any implications?
the lessor has no recourse to the lessee in the event of a default
so the risk of default by the lessee must be very low
what is a cross-border lease?
a financial lease where the lessor and lessee are located in different countries
features of cross-border lease
- usually leveraged
- motivated by differences between the tax regulation of different countries
* different rates of company tax and depreciation shield - Generally structured so that the lessor and lessee can both claim depreciation deductions on the same asset.
cons of cross-border lease
high costs in establishing a CBL –> so it is only used for very expensive assets such as aircraft
requires specialised legal and taxation advice
what is a finance lease
long-term agreement that generally covers most of the economic life of an asset.
transfers benefits and costs of ownership of the asset from the lessor to the lessee
features of financial lease
- non-cancealleable or cancellable only if the lessee pays a substantial penalty to the lessor.
- , all of the risks and rewards associated with ownership of the leased asset are effectively transferred to the lessee
- The lease asset/liability equal to the fair value of the leased property or, if lower, the PV of the minimum lease payments must be recognized
role of lessor and lessee in financial lease
lessor
- legal owner of the asset but has no great interest in matters such as the day-to-day use of the asset
- prefer lessee to purchase asset at the end of the lease term
lessee is responsible for repairs, maintenance and insurance.
financial leases are viewed as what for accounting purposes
¡Viewed as an acquisition for accounting purposes;
- the lessee lists the asset on its balance sheet and incurs depreciation expenses.
- lesseelists the present value of the future lease payments as a liability and deducts the interest portion of the lease payments as an interest expense.
what is an operating lease?
short-term rental agreement
lessors retains the risks and benefits of ownership of the asset
features of operating lease
- the term of the lease is short relative to the economic life of the asset e.g. truck with 15yr economic life leased for 3 yrs
- cancelleable
- leased to multiple users e.g. holiday car
In Australia, operating leases have been limited mainly to?
motor vehicles, computers and multipurpose industrial equipment such as forklifts.
lessor’s role in an operating lease
lessor is responsible for insuring the asset, maintaining it and for payment of any government charge
how does business record operating leases?
Viewed as a rental for accounting purposes
- the lessee reports the entire lease payment as an operating expense
The lessee does not deduct a depreciation expense for the asset and does not report the asset or the lease payment liability on its balance sheet.
disclosed in the footnotes of the lessee’s financial statements.
n Australia, Accounting Standard AASB 117, provides
‘Leases’, provides that the accounting treatment of a lease depends on whether it is classified as an operating lease or a finance lease
Taxation Treatment of Leases
operating leases?
Lessee
- If a leased asset is used to generate taxable income, the lease rentals paid by the lessee are an allowable tax deduction
- ONLY IF IT IS A GENUINE LEASE, DOES NOT APPLY IF IT IS AN INSTALMENT PURCHASE ARRANGEMENT
- depreciation on leased asset cannot be deducted for tax purposes
Taxation Treatment of Leases
operating leases?
lessor
nDepreciation is deductible by the lessor (as the legal owner of the asset), but lease rentals received by the lessor are taxable.
a lessor of a financial lease might do what to avoid their lease from being recognised as an asset/liability
design leases that are, in substance, finance leases but can be classified as operating leases
when is there potential source of gains?
nIf Lessor’s cost of capital is substantially less than the lessee’s cost of capital
- I.e., If Lessor’s tax rate is substantially higher than the lessee’s tax rate (i.e. Lower discount rate)
¡
Cross-border leasing may take advantage of different tax rates and treatments
Why may accelerated depreciation be a source of potential gain?
if Depreciation is accelerated, depreciation tax savings are received early (i.e. the lessor can make better use of depreciation tax deduction.)
why may long lease terms be a potential source of gain
the term of the lease is long and the lease rentals are concentrated during the later part of the lease term, so that tax payments by the lessor are deferred
given the potential sources of gains from leasing
when may leasing most likely be used
leasing is more likely to be used if there are high company tax rates, high depreciation rates and high interest rates.
under an operating lease, what rights does the lessee have?
he lessee may have the right but not the obligation to renew the lease at the end of an initial term.
Second, the lessee may have the right to cancel the lease, either at any time after it has commenced or at any time after an agreed date.
cancellable operating leases enable a lessee to obtain
insurance against an unexpectedly large decline in the value of an asset
the risk of an unexpected decline in value can be particularly high
for assets such as computers, which can become obsolete very quickly, because of changes in technology.
he rentals for an operating lease will reflect
will reflect the costs incurred by the lessor in acquiring and maintaining the asset.
operating lease
should you lease or buy a car if 1 month, 1 year?
where an asset such as a car is needed for a short period of, say, a month or less, it is usually clear that an operating lease will be cheaper than buying the car and then selling it.
f the car is needed for a year or more, most users will find it cheaper to buy rather than lease.
an operating lease is attractive to the lessee if
he annual rental is less than the equivalent annual cost of buying and operating the asset.
While an operating lease will generally be more costly than buying an asset that is needed for an extended period,
there are circumstances where an operating lease can be less costly than buying.
these include?
if the lessor can take advantage of cost savings that are not available to the lessee. e.g. lessor’s can take adv of economies of scale –> car rental companies buy thousands of cars each year and can negotiate volume discounts
- car rental companies probably face lower costs in maintaining, servicing and insuring cars than most other owners.
2. lessee has the option to cancel particularly if the it is no longer needed due to decline of demand or there is premature obsolescence
describe why airline companies may use operating leases
terrorist attack –> decline in demand –> difficult to sell surplus aircraft unless owner is willing to discount price significantly –> better to pay premium to lessor to accept the risk of cancellation.
leasing may be preferred where:
(a) the lessor has an advantage (or advantages) not available to the potential lessee; and (b) the lessor passes on at least some of the advantage(s) to the lessee through reduced lease payments.
adv of leasing
if the potential lessee and lessor are taxed at the same rate?
there should be no taxation advantage associated with leasing.
what if the lessor’s effective tax rate is HIGHER than the lessee’s effective tax rate?
what was found in the US?
a lessor can use allowable deductions as soon as they are available.
lessee benefits if lessor reduces lease payments
the US it has been found that companies with low marginal tax rates use leasing more than companies with high marginal tax rates (Graham, Lemmon & Schallheim 1998)
the adv of tax deductability is taken adv in what kind of lease?
cross-border leases which are structured to take advantage of differences between tax regulations and tax rates between countries
describe how transaction costs is an adv of leasing?
If a lessee defaults, the lessor, as the owner of the asset, can immediately repossess the asset
describe how transaction costs is an adv of leasing?
lessors can immediately repossess the asset. compare this to secured lenders
secured lender, who is likely to face considerable delay, and greater costs, because it may be necessary for a defaulting borrower to be liquidated.
- a liquidator has to be appointed to sell the assets and distribute the proceeds to lenders and other creditors.
For larger companies, leasing may also be more attractive than other sources of finance because
the transaction costs are lower than the cost of issuing securities or negotiating a loan.
conservation of capital
by leasing, a company can conserve its capital for investment elsewhere because lessee can ‘borrow’ 100 per cent of the purchase price of an asset, compared with perhaps 80 per cent in the case of a secured loan
why is the agrument that leasing provides 100% financing controversial?
- lease rentals are payable in advance –> the finance effectively provided by leasing can be much less than the purchase price of the asset e.g. 511800 instead of 600k
- to obtain a finance lease, it is necessary to have some equity capital
Leasing can provide ‘off-balance-sheet’ finance
as a possible adv
In the past lessees were not required to report their lease obligation on the balance sheet, which allowed them to use leasing to increase their access to debt
Leasing can provide ‘off-balance-sheet’ finance
empirical evidence suggests that lease finance is a ___
implications?
empirical evidence suggests that lease finance is a substitute for debt, with the result that companies may not have been able to use leasing to increase their access to other types of debt (Bowman 1980)
leasing can provide “off-balance sheet” finance
what does Accounting Standard AASB 117 now require?
Accounting Standard AASB 117 requires the capitalisation of finance lease obligations, which means that any potential ‘off-balance-sheet financing’ advantage for leasing should no longer be available
further recommendations have been made for AASB 117 to ensure that all non-real estate leases, with a term longer than 12 months, are recognised in companies’ financial statements.
possible adv of leasing
cost of capital?
the discount rate applicable to a given component of the cash flows must be
he discount rate applicable to a given component of the cash flows must be the same for both the lessee and the lessor
it should depend on the risk of the cash flows
possible adv of leasing
cost of capital?
However, if the lessor’s cost of capital is lower (higher) than that of the potential lessee,
the existence of competitive capital markets will result in leasing (buying) being preferred to buying (leasing).
possible adv of leasing
cost of capital?
What circumstances will cause the cost of capital of the lessor and the lessee to differ?
depend on the risks associated with using the asset (in financial lease, borne by lessee, operating, borne by lessor)
Milton Upton (1976) identified relevant risks including
- uncertainty about the asset’s economic depreciation
- uncertainty about the net cash flows from using the asset.
possible adv of leasing
cost of capital
miller and upton (1976) show
the costs of capital for leasing and buying must be the same
If not, one of two results would occur:
leasing would either be dominant—that is, all assets would be leased
or leasing would disappear.
how may agency costs arise from leasing?
separation of ownership and control (the lessee)
agency costs
leasing
how may ownership structure influence leasing?
a manager who has a large ownership stake in the business may prefer to lease business assets in order to reduce personal exposure to asset-specific risks such as the risk of obsolescence.
There can be significant tax advantages for leasing when there is
However
a large difference between the effective income tax rates of the lessor and lessee.
However, under the imputation tax system, any tax advantages of leasing appear to be small when both the lessor and lessee are Australian-owned companies.
how may agency costs arise from leasing?
what creates incentives to lease assets rather than buy them?
Smith and Wakeman (1985) pointed out that management compensation plans can create incentives to lease assets rather than purchase them
how may agency costs arise from leasing?
give an example of how remuneration packages can create incentives to lease?
a manager whose bonus depends on the rate of return on invested capital will favour the leasing of assets unless the present value of future lease payments is included as part of invested capital.
a compensation plan that is not well designed can motivate managers to lease assets when purchasing would be better for shareholders.
In a lease contract, the legal owner of the asset is known
financier or lessor.
leasing and debt may not be perfect substitutes because
they can differ in terms of incentive effects and control of agency costs.
Smith and Wakeman (1985) pointed out that management compensation plans can create incentives to lease assets rather than purchase them.
example of when there is incentive for managers to lease assets
a manager whose bonus depends on the rate of return on invested capital
If the NPV from purchasing an asset is $2000 and the NPV from leasing relative to purchasing is $3000, what should the company do?
Company should lease the asset
NPV leasing = NPV if purchase + NPV leasing relative to purchasing
NPV of leasing = 2000 + 3000 = 5000
the NPV of purchasing the asset is positive, but the NPV of leasing is higher —> This suggests that the company value would increase if the asset were purchased, but would increase by more if the asset were leased.
NPV of lease relative to purchase = $1000; NPV of purchasing = −$5000.
should the computer be leased
NPV leasing = NPV lease relative to purchase + NPV purchasing the total NPV= 1000 - 5000= -4000
the computer should not be leased: leasing is better than purchasing, but both alternatives are unprofitable.
The NPV from purchasing the asset is −$2000, while the NPV from leasing relative to purchasing is $1000. What advice do you give the company representative?
NPV leasing = NPV lease relative to purchase + NPV if purchased
NPV leasing = 1000 -2000 = - 1000
Even though NPV of leasing is better than the NPV of purchasing, both are negative and therefore the company should neither purchase the asset nor lease the asset.
Under a leveraged lease, the lessor finances only
a proportion of the cost of the asset and borrows the remainder from one or more lenders. The most distinctive feature of these loans is that they are non-recourse
The leveraged lease structure is designed to maximise the value of the tax savings associated with ownership of the leased asset
The main disadvantage of leasing is
it is likely to be more costly than owning. This is to be expected, because aircraft lessors will charge for providing the option to cancel the lease.
if an airline wishes to sell surplus aircraft, there are
likely to be delays in finding buyers and the price may be depressed, particularly if other airlines are experiencing similar declines in demand
