A lease is a contractual agreement between a lessor, who owns an asset, and a lessee, who uses the asset. There are two main types of leases from an accounting perspective: operating leases and capital leases. For operating leases, the asset is not recorded on the lessee's balance sheet, while lease payments are expensed over time. For capital leases, the asset and liability are recorded on the lessee's balance sheet similar to a purchased asset. Leases allow companies to acquire assets without large upfront cash outlays and provide off-balance sheet financing advantages.

1. Lease Presentation

2. • The lease is a contractual agreement between
the lessor and the lessee.
• The lease gives the lessee the right to use
specific property.
• The lease specifies the duration of the lease and
rental payments.
• The obligations for taxes, insurance, and
maintenance may be assumed by the lessor or
the lessee.
Leasing: BasicsLeasing: Basics

3. • The lessee, who uses the asset and makes the
lease, or rental, payments.
• The lessor, who owns the asset and receives the
rental payments.
• Note that the lease decision is a financing decision
for the lessee and an investment decision for the
lessor.
Parties to a Lease Transaction

4. Sale and Lease-Back
• A particular type of financial lease.
• Occurs when a company sells an asset it
already owns to another firm and
immediately leases it from them.
• Two sets of cash flows occur:
– The lessee receives cash today from the sale.
– The lessee agrees to make periodic lease
payments, thereby retaining the use of the asset.

5. Leveraged Leases
• A leveraged lease is another type of financial
lease.
• A three-sided arrangement between the
lessee, the lessor, and lenders.
– The lessor owns the asset and for a fee allows the lessee
to use the asset.
– The lessor borrows to partially finance the asset.
– The lenders typically use a nonrecourse loan. This means
that the lessor is not obligated to the lender in case of a
default by the lessee.

6. Overview of Leasing
• Economic Substance of Leases
• A Lease represents a contractual agreement between the
party owning the asset who wants to earn a return on its
investment (the “Lessor”) and the party desiring to use the
asset (the “Lessee”)
• The lessor grants the lessee the right to use the asset in
exchange for a series of lease payments. The lessee expects
that it will earn a return on the use of the asset that is greater
than the cost of the lease.
• In many respects, this transaction is similar to a company
purchasing an asset and financing the purchase with the
issuance of a bond.

7. In Short
• A lease is a contact between the owner of an asset (the
lessor) and the party desiring to use that asset (the
lessee).
• Generally, leases provide for the following terms:
1. The lessor allows the lessee the unrestricted right to use the
asset during the lease term
2. The lessee agrees to make periodic payments to the lessor and
to maintain the asset
3. Title to the asset remains with the lessor, who usually retakes
possession of the asset at the conclusion of the lease.

8. Advantages to Leasing
1. Leases often require much less equity
investment than bank financing.
2. Since leases are contracts between two willing
parties, their terms can be structured in any way
to meet their respective needs.
3. If properly structured, neither the leased asset
not the lease liability are reported on the face of
the balance sheet.

9. Lease Agreement
Is there transfer
of ownership?
Yes
Is there a bargain
purchase option?
Yes
No
Is lease term equal
to or greater than
75% of economic
life ?
Yes
No
Capital
Lease
Operating
Lease
Is present value
of payments
equal to or more
than 90% FMV?
Yes
No
Accounting by LesseeAccounting by Lessee

10. A bargain purchase option
• allows the lessee to buy the leased asset
• at a price significantly lower than the asset’s
fair value when the option is exercisable
The difference between the option price, and
the fair value (when the option is exercisable)
as determined at the inception of the lease
must render the option reasonably assured.
The Bargain Purchase OptionThe Bargain Purchase Option

11. In determining the present value of the lease
payments, three important factors are
considered:
1) Minimum lease payments the lessee is
expected to make under the lease,
2) Executory costs (insurance, taxes, and
maintenance), and
3) Discount rate (used by the lessee to determine
the present value of minimum lease payments)
The Recovery of Investment TestThe Recovery of Investment Test
(90% Test)(90% Test)

12. Operating Lease for Lessee
• Operating lease method. Under this method,
neither the lease asset nor the lease liability is on the balance
sheet.
• Lease payments are recorded as rent expense when paid.
• Lease payments under an operating lease shall be recognised
as an expense on a straight-line basis over the lease term
unless another systematic basis is more representative of the
time pattern of the user’s benefit.

13. Benefits of Operating Leases
1. Leased asset is not reported on the balance sheet.
1. Lease liability is not reported on the balance sheet.
1. For the early years of the lease term, rent expense
reported for an operating lease is less than the
depreciation and interest expense reported for a
capital lease.

14. Capital Lease for Lessee
• Capital lease method.
• This method requires that both the lease asset and
the lease liability be reported on the balance sheet.
• The leased asset is depreciated like any other long-
term asset.
• The lease liability is amortized like a note, where
lease payments are separated into interest expense
and principal repayment.

15. Capital Lease for Lessee
• Capital lease method.
• Therefore there is both a finance charge and a
reduction of the outstanding liability.
• The Finance charge should be at a periodic rate of
return on the remaining balance of liability for each
period.

16. Capital Leases
• Capital leases
– Effectively an installment purchase
– Lessee assumes rights and risks of ownership
– Treated as purchases
• Examples of what constitutes a capital lease
– PV of lease payments is the FMV of the asset
– Period of the lease approximates the assets life
– There is a bargain purchase price

17. Let’s summarize the two ways in which the same lease
could be accounted for in the books of the Lessee:
Operating lease
Capital lease
•No asset and liability are recorded on the lessee’s
balance sheet
•Lease payments are reported as expense when paid.
•Both the leased asset and the lease liability are
recorded on the lessee’s balance sheet
•Subsequently, depreciation expense is reported
relating to the asset and interest expense is recorded
on the liability.

18. Accounting and Leasing
Balance Sheet
Truck is purchased with debt
Truck RM100,000 Debt RM100,000
Land RM100,000 Equity RM100,000
Total Assets RM200,000 Total Debt & Equity RM200,000
Operating Lease
Truck Debt
Land RM100,000 Equity RM100,000
Total Assets RM100,000 Total Debt & Equity RM100,000
Capital Lease
Assets leased RM100,000 Obligations under cap. lease RM100,000
Land RM100,000 Equity RM100,000
Total Assets RM200,000 Total Debt & Equity RM200,000

19. Accounting for Leases - Lessors
•

20. Operating Lease – For Lessor
• The Lessor will recognize the leased asset on its
Balance Sheet.
• Lessor will claim depreciation on the leased asset.
• Lease income from operating leases shall be
recognised in income on a straight-line basis over the
lease term, unless another systematic basis is more
representative of the time pattern in which use
benefit derived from the leased asset is diminished.

21. Rental Income on a straight line basis
• How are lease payments determined?
– The lessor computes a payment that will yield a desired
rate of return on fair value of its leased asset. Once
we know the desired rate of return and the term of the
lease, we use the present value of an annuity table to
compute the payment amount, similar to the way we
computed the present value of a bond.
Chosen to provide a desired rate of return on the leased asset
(like a bond yield)
Payment = FMV leased asset
PV Factor

22. Capital Lease for Lessor
• Lessors shall recognise assets held under a finance lease in their Balance
Sheet as a receivable at an amount equal to the net investment in the
lease (Asset)
• The Payments shall be recognized as interest expense and Principal
repayments.
• The Principal repayments will reduce the value of the receivable on the
Balance Sheet (Receivables).
• The interest will be recognized as Income
• The recognition of Interest Income should be based on a pattern
reflecting the Lessor’s Net outstanding investment in the lease.

23. In general, more expense is reported for capital leases in the early years of
the lease life due to the increased interest expense.
This fact, coupled with the desire to keep liabilities off of the balance
sheet, provides an incentive for companies to structure leases with terms
that will not require lease capitalization.
Airlines are major users of leases for most of their airplanes. And, the
majority of these leases are structured as operating leases. For example, look at
Delta Air Lines:

24. Examples of companies that utilize leasing to acquire assets:
• Companies like General Electric Capital Services, a subsidiary of General
Electric Company, which leases a broad range of equipment, Ryder System, Inc.,
the truck leasing company, real estate investment companies, and a large
number of other companies.
Who does the leasing?
Delta Air Lines leases many of its airplanes
Federal Express leases a portion of its delivery trucks

25. Leasing Advantages
• May avoid obsolescence of assets.
The lessee can lease a “newer” version of the asset when the lease term
is completed and the lessee bears the risk of loss on sale of the asset
• Flexibility of contracting.
Since a lease is a contractual agreement, it can contain any terms that
meet the needs of both parties.
• Low or no down-payment preserves capital.
Many leases are structured with less of a down payment than would
be required if the lessee were to own the asset outright. The lessee’s
funds are, thus, preserved for other business uses.
• Lessor’s borrowing rate may be less than lessee’s.
If the lessee is small or a new business, its borrowing rate may be
higher than the larger, more established, leasing company which can
pass on the savings to the lessee.
• And probably most important ...

26. “Off-Balance Sheet Financing”
If the lease is structured “properly” no asset and liability are
recorded on the lessee’s balance sheet and the financing is
“off-balance sheet”.
There are two main benefits that result:
Since the asset is not recorded, financial ratios like total asset turnover appear
stronger and the lessee looks like it is managing its assets more effectively.
Since the liability is not recorded, the debt-to-equity ratio appears stronger
and the lessee looks less risky.

27. Why is Off-Balance Sheet Financing
Important?
• In other words, why are firms so interested
in “hiding” debt?
– If analysis reveals that debt is excessive,
companies may face the prospect of a reductions
in bond ratings, resulting in higher cost of debt.
– Likewise, excessive leverage can result in a higher
cost of equity capital and a consequent reduction
in stock price.

28. Motives for using Off-Balance Sheet
Financing
• In general, companies desire to present a balance sheet
with sufficient liquidity and less indebtedness.
• The reasons for this are as follows: liquidity and the level
of indebtedness are viewed as two measures of
solvency.
• Companies that are more liquid and less highly
financially leveraged are generally viewed as less likely to
go bankrupt.
• As a result, the risk of default on their bonds is less,
resulting in a higher rating on the bonds and a lower
interest rate.

29. Off-Balance Sheet Financing
• Off-balance sheet financing means that either
liabilities are kept off of the face of the
balance sheet.

30. Capitalizing Operating Leases for Analysis
Purposes
1. Determine the discount rate to compute the
present value of the operating lease
payments.
This can be inferred from the capital lease
disclosures, or one can use the company’s debt
rating and recent borrowing rate for
intermediate term secured obligations as
disclosed in its long-term debt footnote.
1. Compute the present value of the operating
lease payments.
2. Add the present value computed in step 2 to
both assets and liabilities.

31. Capitalization of Midwest Air Operating
Leases

32. Footnote Disclosures of Lessees

33. NPV Analysis of the Lease-vs.-Buy Decision
• A lease payment is like the debt service on a
secured bond issued by the lessee.
• In the real world, many companies discount
both the depreciation tax shields and the
lease payments at the after-tax interest rate
on secured debt issued by the lessee.

34. Reasons for Leasing
• Good Reasons
– Taxes may be reduced by leasing.
– The lease contract may reduce certain types of
uncertainty.
– Transactions costs can be higher for buying an
asset and financing it with debt or equity than for
leasing the asset.
• Bad Reasons
– Accounting

35. Example of how a finance lease
resembles a loan
• A trader who wants an asset costing £1,000 could borrow
£1,000 at 10% from a bank and use the money to buy the
asset.
• The trader will pay the bank the interest and also repay the
capital.
• The capital could either be repaid in one lump sum at the end
of the loan period
• or it could be structured like a repayment mortgage, with
small capital payments and large interest payments at first
• and, towards the end, large capital payments and small
interest payments.

36. • The same commercial result can be achieved with a
finance lease.
• The finance lessor (often a subsidiary of a bank) buys
the asset for £1,000 and leases it to the lessee.
• The lessee is the one who uses the asset.
• The lessor charges the lessee rentals which, over the
term of the lease, will repay the capital with a
commercial rate of 'interest'.

37. • The 'interest' charges included in a finance lease agreement
may fluctuate with base rate or with other changes (such as
tax rate or régime changes) and so there will often be
provisions in the lease which spell out the consequences.
• Usually, the aim is to leave the finance lessor making its
desired turn on the finance whatever happens: the lessee
picks up any increased costs and benefits from any reduced
costs.