The Lease versus Buy Decisions

General incentives for leasing:

• Lessee ownership is closely held so that risk reduction is important.
• Lessor has market power and can generate higher profits by leasing the asset than selling it.
• Asset is not specialized to the firm.
• Asset's value is not sensitive to use or abuse (as owner takes better care of asset than lessee).
• Tax incentives: If the lessee is in a low tax bracket and the lessor in a high tax bracket there are tax benefits to structuring the lease as an operating lease. The reason for this is that by leasing the asset the lessor can retain the greater tax benefits from owning the asset (such as accelerated depreciation methods for tax purposes).

Finance versus Operating Leases

Operating leases allow the lessee to use the property for only a portion of its economic life.

• Lessee reports only the required lease payments as they are made. There is no balance sheet recognition of the property.
• All of the risks and rewards of ownership remain with the lessor. For the lessor:
  • Payments received are recognized as income.
  • The property remains on the balance sheet and is depreciated over time.

In an operating lease the lessee is not seen as becoming the owner of the asset. In a capital lease the lessee is seen as becoming the owner.

Capital leases (CL) involve effective transfer of all risk and benefits of property to the lessee. For accounting purposes the transaction is treated as though the lessor has granted the lessee a loan to purchase the asset. The lessee recognizes the asset and a loan on its balance sheet and treats the lease payments as part of interest expense, and part of repayment of the principal on the loan. The lessee then also recognizes depreciation on the asset.

Generally lessees prefer leases to be classified as operating leases. They do not have to recognize the asset and loan on their balance sheet although they still receive all of the benefit of using the asset. Therefore operating leases result in higher profitability ratios and reduce reported leverage for lessees.

Generally lessors prefer leases to be classified as capital leases. This allows them to potentially recognize a profit on the sale of the asset, though the substance of the transaction is similar to installment sales or financing. This also allows them to be able to derecognize the asset from their balance sheet.

Practice Question 1

Which of the following is a factor that would cause a firm not to use capital leases?

A. High effective tax rates.
B. Lease terms that are equal to the life of the asset.
C. The firm has a high level of debt.

Correct Answer: C

If a firm has high level of debts already, adding a capital lease will increase its debt, which could affect the debt ratios unfavorably.

Practice Question 2

What is a conventional rental agreement that transfers ownership rights to the lessee at the end of the rental term?

A. capital lease
B. operating lease
C. direct financing lease
D. sales-type lease

Correct Answer: A

An operating lease is a conventional rental agreement that does not transfer ownership rights to the lessee at the end of the rental term.

Practice Question 3

Select the correct statement(s):

I. It is easier for a lease to be classified as an operating lease under IFRS standards than under GAAP.
II. If a lease with rising rental payments is classified as an operating lease, the lease expense and cash flow will be identical for the lessee.
III. It's possible that the lessee treats a lease as a capital lease but the lessor treats the same lease as an operating lease.

Correct Answer: I and III

I is true. IFRS standards lack the quantitative criteria of SFAS 13.
II is false. SFAS 13 mandates the use of the straight-line method of recognizing periodic payments.
III is true. This will happen if a lease meets any of the four criteria for the lessee but not the two additional criteria for the lessor.

Practice Question 4

A firm might wish to use a capital lease under which of the following conditions?

A. The firm has debt covenants that restrict the amount of debt
B. Lease terms that are equal to the life of the asset
C. High effective tax rates

Correct Answer: C

When a firm is in a high tax bracket, there are certain tax advantages to owning assets, and a capital lease would increase asset ownership.

Practice Question 5

Which of the following does NOT favor a capital lease?

A. Lessee is in a high tax bracket.
B. Compensation contracts based on return on capital benchmarks.
C. Lessor can obtain a higher salvage value.

Correct Answer: B

Capitalizing a lease increases total assets and the capital base. This discourages capital leases as profits have to be higher to meet or exceed return on capital benchmarks.

Practice Question 6

Which of the following statements characterizes an operating lease?

A. The lessor records depreciation expense and lease revenue.
B. The lessee records amortization expense and interest expense.
C. The lessor transfers title of the leased property to the lessee only for the duration of the lease term.

Correct Answer: A

For operating leases the lessee records rent expense and the lessor would record the related revenue and would amortize the asset.

Practice Question 7

A capital lease:

A. Results when the lease term is less than 50% of estimated economic life.
B. Is used for off-balance-sheet accounting.
C. Transfers the risks and rewards of ownership.

Correct Answer: C

It is reported on the balance sheet.