Chapter 22 Notes
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Chapter 22 Leasing Notes
•lessee one who receives the use of assets under a lease
•lessor one who conveys the use of assets under a lease
22.1 Types of Leases
•lease contractual arrangement to grant use of specific fixed assets for specified time in exchange for payment, usually in form
of rent; operating lease is a ST cancellable arrangement, whereas a financial, or capital, lease is a LT non-cancellable agreement
•direct lease lease under which a lessor buys equipment from a manufacturer and leases it to a lessee
•sales-type lease arrangement whereby a firm leases its own equipment thereby competing with independent leasing company
•operating lease period of contract is less than the life of the equipment and the lessor pay alls maintenance and servicing costs
•this form of leasing has several important characteristics:
1) Operating leases are usually not fully amortized. This means that the payments required under the terms of the lease are not
enough to recover the full cost of the asset for the lessor. This occurs because the term or life of the operating lease is
usually less than the economic life of the asset. Thus, the lessor must expect to recover the costs of the asset by renewing
the lease or by selling the asset for its residual value.
2) Operating leases usually require the lessor to maintain and insure the leased assets.
3) The cancellation option gives the lessee the right to cancel the lease contract before the expiration date. If the option to
cancel is exercised, the lessee must return the equipment to the lessor. The value of a cancellation clause depends on
whether future technological and/or economic conditions are likely to make the value of the asset to the lessee less than the
value of the future lease payments under the lease.
•financial lease long-term non-cancellable lease, generally requiring the lessee to pay all maintenance costs
•the characteristics of a financial lease are:
1) Financial leases do not provide for maintenance or service by the lessor.
2) Financial leases are fully amortized.
3) The lessee usually has a right to renew the lease on expiration.
4) Financial leases cannot be cancelled. In other words, the lessee must make all payments or face the risk of bankruptcy.
•sale and lease-back an arrangement whereby a firm sells its existing assets to a financial company, which then leases them
back to the firm; this is often done to generate cash
•in a sale and lease-back, two things happen—(1) the lessee receives cash from the sale of the asset; and (2) the lessee makes
periodic lease payments, thereby retaining use of the asset
•leveraged lease tax-oriented leasing arrangement that involves one or more third-party lenders
•a leveraged lease is a 3-sided arrangement among the lessee, the lessor, and the lenders:
1) As in other leases, the lessee uses the assets and makes periodic lease payments.
2) As in other leases, the lessor purchases the assets, delivers them to the lessee, and collects the lease payments. However,
the lessor puts up no more than 40 to 50 percent of the purchase price.
3) The lenders supply the remaining financing and receive interest payments from the lessor.
•the lender is protected in 2 ways—(1) the lender has a first lien on the asset; and (2) in the event of loan default, the lease
payments are made directly to the lender and not to the lessor
22.2 Accounting and Leasing
•off-balance-sheet financing financing that is not shown as a liability on a company’s balance sheet
•CICA 3605 states that a lease must be classified as a capital one if at least one of the following 4 criteria are met:
1) The lease transfers ownership of the property to the lessee by the end of the term of the lease.
2) The lessee has an option to purchase asset at a price below fair market value (bargain purchase price) when lease expires.
3) The lease term is 75% or more of the estimated economic life of the asset.
4) The present value of the lease payments is at least 90% of the asset’s fair market value at the start of the lease.
22.3 Taxes and Leases
•if CRA detects one or more of the following, the lease will be disallowed:
1) The lessee automatically acquires title to the property after payment of a specified amount in the form of rentals.
2) The lessee is required to buy the property from the lessor during or at the termination of the lease.
3) The lessee has the right during or at the expiration of the lease to acquire the property at a price less than fair market value.
22.7 Debt Displacement and Lease Valuation
•debt displacement the amount of borrowing that leasing displaces; firms that do a lot of leasing will be forced to cut back on
borrowing; the benefits of debt capacity will be lost, particularly the lower taxes associated with interest expense
22.9 Reasons for Leasing
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