© 2000 John Petroff
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© 2000 John Petroff |
Financial leases can be arranged with most major commercial banks and other specialized financial intermediaries. The leasing company or bank, i.e. the lessor, is instructed by a manufacturer or by the firm (i.e. lessee), as to the equipment that will be used, and that the bank will own. One version is when the corporation already owns the equipment that it wishes to lease. In that case, the equipment must first be sold by the corporation to the leasing company, and the transaction is, therefore, known as "sale and lease back". Financial leases are also known as capital leases, although technically, capital leases are arranged by the manufacturer rather than the finance company or the lessee.
As opposed to operating leases which are cancelable, essentially, financial leases are non-cancelable for the life of the asset, with payments representing practically the entire value of the asset, and maintenance charges assumed by the lessee. From an accounting stand point, capital leases must be capitalized by the lessee in the United States if one of the following is applicable: ownership passes to lessee at termination of lease, or lessee has an option to buy at bargain price, or the lease term extends for 75% or more of the life of the asset, or the present value of lease payments amounts to 90% or more of the value of the asset. Capitalization means that the lease must be shown on the balance sheet as an asset and as a non-current liability for the present value of lease payments net of executory costs (i.e. insurance, taxes) to be paid by the lessor. In addition, explanations must appear in notes to financial statements. The capitalized lease is amortized in the same manner as any fixed asset is depreciated. The lease obligations (i.e. those shown as non-current liability) are reduced by the lease payment coming due in the current year. Often the equipment is transferred to the user firm (i.e. lessee) at the termination of the lease.
Compared to a loan backed by a mortgage
on the equipment, the lease offers only one more level of security
to the lender: outright ownership. Thus the lease could cost a
little less than an equivalent loan because it is less risky.
But that is usually not the reason for using a lease rather than
a loan. The reasons can be
- lessee is not able to take full advantage of depreciation deduction,
tax credits or other special tax advantages because, for instance,
it expects decreased profits;
- in general, income tax rate of lessor is higher than that of
lessees, especially if lessees are small firms;
- cost of capital of lessor is lower than the cost of capital
of lessees.
These are rather special circumstances. This suggests that there
is very little economic difference between mortgaged loan and
capital leasing. From an accounting point of view also, to the
extent that capital leases are capitalized, the effect on the
balance sheet and financial position of the lessee does not change.
The only consequence is that an analyst must recognize the capital
leases in other non-current liabilities and add them to long term
debt.
In the case of sale and lease back, the lessee may have a capital gain on the sell of the equipment when the lease is set up (i.e. if the corporation paid originally less for the equipment than it sells it for to the finance company). Then, the gain is shown as a deferred gain on sale and leaseback transaction in the other non-current liabilities section of the balance sheet, and it is amortized over the life of the lease (as a reduction of the lease expense shown in the income statement).
See review questions Q-12E2.1 through Q-12E2.8.
See research assignment R-12E2.1.
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