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As far as the lessee is concerned, it is the use of the asset that is important, not neces-
sarily who has title to it. One way to obtain the use of an asset is to lease it. Another
way is to obtain outside financing and buy it. Thus, the decision to lease or buy amounts
to a comparison of alternative financing arrangements for the use of an asset.
Figure B.1 compares leasing and buying. The lessee, Sass Company, might be a hos-
pital, a law firm, or any other firm that uses computers. The lessor is an independent
leasing company that purchased the computer from a manufacturer such as Hewlett-
Packard (HP). Leases of this type, in which the leasing company purchases the asset
from the manufacturer, are called direct leases. Of course, HP might choose to lease its
own computers, and many companies, including HP and some of the other companies
mentioned previously, have set up wholly owned subsidiaries called captive finance
companies to lease out their products.1
As shown in Figure B.1, whether it leases or buys, Sass Company ends up using the
asset. The key difference is that in one case (buy), Sass arranges the financing,
purchases the asset, and holds title to the asset. In the other case (lease), the leasing
company arranges the financing, purchases the asset, and holds title to the asset.


OPERATING LEASES
Years ago, a lease in which the lessee received an equipment operator along with the
equipment was called an operating lease. Today, an operating lease (or service lease)
OPERATING LEASE
is difficult to define precisely, but this form of leasing has several important character-
Usually a shorter-term lease
istics.
under which the lessor is
First of all, with an operating lease, the payments received by the lessor are usually
responsible for insurance,
not enough to allow the lessor to fully recover the cost of the asset. A primary reason is
taxes, and upkeep. May be
that operating leases are often relatively short-term. Therefore, the life of the lease may
cancelable by the lessee on
be much shorter than the economic life of the asset. For example, if you lease a car for
short notice.
two years, the car will have a substantial residual value at the end of the lease, and the
lease payments you make will pay off only a fraction of the original cost of the car. The
lessor in an operating lease expects to either lease the asset again or sell it when the
lease terminates.
A second characteristic of an operating lease is that it frequently requires that the les-
sor maintain the asset. The lessor may also be responsible for any taxes or insurance. Of
course, these costs will be passed on, at least in part, to the lessee in the form of higher
lease payments.
The third, and perhaps most interesting, feature of an operating lease is the cancela-
tion option. This option can give the lessee the right to cancel the lease before the ex-
piration date. If the option to cancel is exercised, the lessee returns the equipment to the
lessor and ceases to make payments. The value of a cancelation clause depends on
whether technological and/or economic conditions are likely to make the value of the
asset to the lessee less than the present value of the future lease payments under the
lease.
To leasing practitioners, these three characteristics define an operating lease. How-
ever, as we will see shortly, accountants use the term in a somewhat different way.


1 Inaddition to arranging financing for asset users, captive finance companies (or subsidiaries) may purchase
their parent company™s accounts receivable. General Motors Acceptance Corporation (GMAC) and General
Electric (GE) Capital are examples of captive finance companies.
Leasing 549


FIGURE B.1
Leasing vs. Buying

Buy Lease
Sass Co. buys asset and uses asset; Sass Co. leases asset from lessor;
financing raised by debt lessor owns asset

Manufacturer Manufacturer
of asset of asset


Sass Co. arranges
Lessor arranges
financing and
financing and
buys asset from
buys asset
manufacturer

Sass Co. Lessor Lessee (Sass Co.)
1. Uses asset 1. Owns asset 1. Uses asset
2. Owns asset 2. Does not use asset 2. Does not own asset
Sass Co. leases
asset from lessor
If Sass Co. buys the asset, then it will own the asset and use it. If Sass Co. leases the asset, the lessor will own the
asset, but Sass Co. will still use it as the lessee.

If Sass Co. buys the asset, then it will own the asset and use it. If Sass Co. leases the asset, the lessor will own the asset, but Sass Co. will
still use it as the lessee.



FINANCIAL LEASES
A financial lease is the other major type of lease. In contrast to the situation with an
FINANCIAL LEASE
operating lease, the payments made under a financial lease (plus the anticipated resid-
Typically a longer-term, fully
ual, or salvage, value) are usually sufficient to fully cover the lessor™s cost of purchas-
amortized lease under which
ing the asset and pay the lessor a return on the investment. For this reason, a financial
the lessee is responsible for
lease is sometimes said to be a fully amortized or full-payout lease, whereas an operat-
main-tenance, taxes, and
ing lease is said to be partially amortized. Financial leases are often called capital
insurance. Usually not
leases by the accountants.
cancelable by the lessee
With a financial lease, the lessee (not the lessor) is usually responsible for insurance,
without penalty.
maintenance, and taxes. It is also important to note that a financial lease generally can-
not be canceled, at least not without a significant penalty. In other words, the lessee
must make the lease payments or face possible legal action.
The characteristics of a financial lease, particularly the fact that it is fully amortized,
make it very similar to debt financing, so the name is a sensible one. There are three
types of financial leases that are of particular interest: tax-oriented leases, leveraged
leases, and sale and leaseback agreements. We consider these next.

Tax-Oriented Leases
TAX-ORIENTED LEASE
A lease in which the lessor is the owner of the leased asset for tax purposes is called a
A financial lease in which the
tax-oriented lease. Such leases are also called tax leases or true leases. In contrast, a
lessor is the owner for tax
conditional sales agreement lease is not a true lease. Here, the “lessee” is the owner for
purposes. Also called a true
tax purposes. Conditional sales agreement leases are really just secured loans. The fi-
lease or a tax lease.
nancial leases we discuss in this material are all tax leases.
Tax-oriented leases make the most sense when the lessee is not in a position to use
tax credits or depreciation deductions that come with owning the asset. By arranging
for someone else to hold title, a tax lease passes these benefits on. The lessee can ben-
550 APPENDIX B


efit because the lessor may return a portion of the tax benefits to the lessee in the form
of lower lease costs.

A Leveraged Leases
LEVERAGED LEASE
financial lease in which the A leveraged lease is a tax-oriented lease in which the lessor borrows a substantial por-
lessor borrows a substantial tion of the purchase price of the leased asset on a nonrecourse basis, meaning that if the
fraction of the cost of the lessee stops making the lease payments, the lessor does not have to keep making the
leased asset on a loan payments. Instead, the lender must proceed against the lessee to recover its invest-
nonrecourse basis. ment. In contrast, with a single-investor lease, if the lessor borrows to purchase the
asset, the lessor remains responsible for the loan payments regardless of whether or not
the lessee makes the lease payments.

Sale and Leaseback Agreements
SALE AND LEASEBACK
A sale and leaseback occurs when a company sells an asset it owns to another party
A financial lease in which the
and immediately leases it back. In a sale and leaseback, two things happen:
lessee sells an asset to the
lessor and then leases it
1. The lessee receives cash from the sale of the asset.
back.
2. The lessee continues to use the asset.
Often, with a sale and leaseback, the lessee may have the option to repurchase the
leased asset at the end of the lease.
An example of a sale and leaseback occurred in July 1985 when the city of Oakland,
California, used the proceeds from the sale of its city hall and 23 other buildings to help
meet the liabilities of its $150 million Police and Retirement System, which was un-
derfunded by about $60 million. As part of the same transaction, Oakland leased back
the buildings to provide for their continued use.
A little more recently, in March 1998, cash-strapped Korean Airlines announced
plans to sell 14 of its aircraft and then lease them back from the purchaser. Although
the purchaser was not revealed, it was widely understood that KAL was working with
General Electric Capital Aviation Services, one of the largest lessors specializing in air-
craft. Under terms of the deal, KAL would raise about $386 million in badly needed
cash without giving up control of its planes.


CONCEPT QUESTIONS
• What are the differences between an operating lease and a financial lease?
• What is a tax-oriented lease?
• What is a sale and leaseback agreement?




Accounting and Leasing
Before November 1976, leasing was frequently called off“balance sheet financing. As
the name implies, a firm could arrange to use an asset through a lease and not neces-
sarily disclose the existence of the lease contract on the balance sheet. Lessees had to
report information on leasing activity only in the footnotes to their financial statements.
In November 1976, the Financial Accounting Standards Board (FASB) issued its
Statement of Financial Accounting Standards No. 13 (FASB 13), “Accounting for
Leases.” The basic idea of FASB 13 is that certain financial leases must be “capital-
Leasing 551


ized.” Essentially, this requirement means that the present value of the lease payments
must be calculated and reported along with debt and other liabilities on the right-hand
side of the lessee™s balance sheet. The same amount must be shown as the capitalized
value of leased assets on the left-hand side of the balance sheet. Operating leases are
not disclosed on the balance sheet. Exactly what constitutes a financial or operating
lease for accounting purposes will be discussed in just a moment.
The accounting implications of FASB 13 are illustrated in Table B.1. Imagine a firm
that has $100,000 in assets and no debt, which implies that the equity is also $100,000.
The firm needs a truck costing $100,000 (it™s a big truck) that it can lease or buy. The
top of the table shows the balance sheet assuming that the firm borrows the money and
buys the truck.
If the firm leases the truck, then one of two things will happen. If the lease is an op-
erating lease, then the balance sheet will look like the one in Part B of the table. In this
case, neither the asset (the truck) nor the liability (the present value of the lease pay-
ments) appears. If the lease is a capital lease, then the balance sheet will look more like
the one in Part C of the table, where the truck is shown as an asset and the present value
of the lease payments is shown as a liability.2
As we discussed earlier, it is difficult, if not impossible, to give a precise definition
of what constitutes a financial lease or an operating lease. For accounting purposes, a
lease is declared to be a capital lease, and must therefore be disclosed on the balance
sheet, if at least one of the following criteria is met:
1. The lease transfers ownership of the property to the lessee by the end of the term of
the lease.

TABLE B.1
Leasing and the balance
sheet
A. Balance Sheet with Purchase
(the company finances a $100,000 truck with debt)
Truck $100,000 Debt $100,000
Other assets $100,000 Equity $100,000
Total assets $200,000 Total debt plus $200,000
equity
B. Balance Sheet with Operating Lease
(the company finances the truck with an operating lease)
Truck $000,000 Debt $000,000
Other assets $100,000 Equity $100,000
Total assets $100,000 Total debt plus $100,000
equity
C. Balance Sheet with Capital Lease
(the company finances the truck with a capital lease)
Assets under $100,000 Obligations under $100,000
capital lease capital lease
Other assets $100,000 Equity $100,000
Total assets $200,000 Total debt plus $200,000

In the first case, a $100,000 truck is purchased with debt. In the second case, an operating lease is used; no balance
sheet entries are created. In the third case, a capital (financial) lease is used; the lease payments are capitalized as a
liability, and the leased truck appears as an asset.
2 We have made the simplifying assumption that the present value of the lease payments under the capital
lease is equal to the cost of the truck. In general, it is the present value of the payments that must be reported,
not the cost of the asset.
552 APPENDIX B


2. The lessee can purchase the asset at a price below fair market value (bargain pur-
chase price option) when the lease expires.
3. The lease term is 75 percent or more of the estimated economic life of the asset.
4. The present value of the lease payments is at least 90 percent of the fair market value
of the asset at the start of the lease.
If one or more of the four criteria are met, the lease is a capital lease; otherwise, it
is an operating lease for accounting purposes.
A firm might be tempted to try and “cook the books” by taking advantage of the
somewhat arbitrary distinction between operating leases and capital leases. Suppose a
trucking firm wants to lease a $100,000 truck. The truck is expected to last for 15 years.
A (perhaps unethical) financial manager could try to negotiate a lease contract for 10
years with lease payments having a present value of $89,000. These terms would get
around Criteria 3 and 4. If Criteria 1 and 2 were similarly circumvented, the arrange-
ment would be an operating lease and would not show up on the balance sheet.
There are several alleged benefits from “hiding” financial leases. One of the advan-
tages of keeping leases off the balance sheet has to do with fooling financial analysts,
creditors, and investors. The idea is that if leases are not on the balance sheet, they will
not be noticed.
Financial managers who devote substantial effort to keeping leases off the balance
sheet are probably wasting time. Of course, if leases are not on the balance sheet, tra-
ditional measures of financial leverage, such as the ratio of total debt to total assets, will
understate the true degree of financial leverage. As a consequence, the balance sheet
will appear “stronger” than it really is. But it seems unlikely that this type of manipu-
lation would mislead many people.

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