Leasing

LEASIN
G
MohammadMaksudulHuqChowdhury

LEASING
Leasing is a typical financing arrangement. It is an
agreement which allows one party to use the asset
without having the title of it. From an economic
perspective, leasing can be defined as “a contract
between two parties where one party (the lessor)
provides an asset for usage to another party (the
lessee) for a specified period of time, in return for
specified payments” (Fletcher et. al., 2005). This is
also reflected in accounting-related definitions:
According to the Accounting Standard IAS 17 “a
lease is an agreement whereby the lessor conveys
to the lessee in return for a payment or series of
payments the right to use an asset for an agreed
period of time”.

LEASING
Leasing is referred to as asset based financing. As
lessors retain ownership of the assets they lease
throughout the life of the contract, these leased
assets are therefore an inherent form of collateral in
such contracts.
Conventional bank lending focuses on the loan
repayment by the borrower from two sources: a
primary source, the cash flow generation, and a
secondary source, credit enhancements and
collateral. Leasing is focused on the lessee’s ability
to generate cash flows from the business operations
to service the lease payments, as the lessor retains
legal ownership of the asset.

LEASING
Hence, leasing separates the legal ownership of an
asset from its economic use. Ownership of the asset
may or may not pass to the customer at the end of
the lease contract. Contracts, where legal ownership
of the asset passes directly to the customer at the
start of the agreement, are not considered to be
leases.

Parties of Leasing
There are two parties:
Lessor : Owner of the asset at the
beginning of the contract
Lessee : User of the asset.

Why Do We Go for Leasing
1. Facilitates the acquisition of needed equipment.
2. Makes available funds that would otherwise be
tied up in the ownership of fixed assets.
3. Possible tax advantages.
4. Possible improvement of the statement of
financial position (B/S).

Types of Leasing
Four most important types:
1. Operating/Service lease,
2. Financial/Net lease,
3. Sale and lease back and
4. Combination lease.

Operating/Service Lease
1. Provides for both financing and maintenance
2. Not fully amortized. Lessor expects to recover all
costs from subsequent renewal payments or
residual values on disposal.
3. Often gives the lessee the right to cancel the
lease before term.
4. Lessor bears the risk of obsolescence.
5. Used for both customized equipment/asset and
standard equipment/asset.

Financial/Net Lease
1. Does not provide for maintenance service.
2. Not cancelable.
3. Generally fully amortized. Added rent to the
lessor.
4. Lessee bears the risk of obsolescence.
5. The lease happens through a leasing company
buying a new equipment chosen by the lessee.
6. Used for Standard type of equipment/asset.

Sale and Leaseback
1. Under a sale and leaseback, a firm that owns a
property sells it to another firm and
simultaneously executes an agreement to lease
the property back for a stated period.
2. An alternative to a mortgage.
3. Considered as a special type of financial lease.

Combination Lease
It combines some features of different types of lease.

Leasing Credit Criteria, Terms & Rates
Lease financing techniques and terms differ
depending on:
• the lessor,
• the length of lease,
• the equipment or assets leased and
• the prevailing interest rate.

Leasing Credit Requirement
The standards of granting lease are similar to
lending
• But less stringent than borrowing.
• Lessor is interested in:
a. Financial condition of lessee and
b. Other pertinent business information.
• Generally leasing companies are less restrictive
than bank with respect to documentation and
financial strength of lessee.
• Primary considerations of a leasing company
a. Intrinsic value of the equipment
b. Marketability of equipment
c. Cash flow of lessee

Length of Lease Period
• Length of lease period is between 2 years and 10
years in majority cases.
• Leases for less than 3 years are usually for rolling
stock (trucks, forklifts etc.) and office equipments
(computers, photocopiers etc.).

What can be done after the expiry of
lease terms?
Three alternatives for the lessee:
• New lease with a new asset.
• Purchase the property from lessor for residual value.
• Renew the lease for residual rent.

Alternatives after Lease Period
• New Lease with New Asset is the right choice when
the asset is rapidly changing in cost and efficiency
(e.g. computers get obsolete).
• Purchase the Property at a Residual Value
(Original Cost + Interest) – (Rents Paid)
- FASB defines residual value as the fair
market value at the end of lease term.
- No set practices determining the residual
purchase prices, but typically 10% of
original cost is charged.

Alternatives after Lease Period
• Purchase the Property at a Residual Value
(Continued)
- The use of fixed purchase price option may
prevent classification of lease agreement a true
lease for tax purpose. Thus it may remove some
of the depreciation and investment credit options
available to lessor.
• Renew the lease at reduced rent: This option would
be exercised if doubt remained about whether to
purchase the asset.
- Generally, renewed leases require reduced
rent (2-5% of original list price)
- Sometimes renewed leases incorporate
declining rent.

Lease Rates
• Lease rates vary widely depending on the risks
involved.
• More specialized the equipment, higher the risk.
• Longer lease term, higher the risk to the lessor.
• Often Add-on-Interest method is applied in
determining lease rates.
 Add-on-percentage is multiplied by the contract
term (in years) to get the total charge.
For example, 5% add-on interest for Tk.200,000 in 6
year lease.
Add-on-amount = (6 x 5% of 200,000)
= Tk.60,000
Total Charge = 200,000 + 60,000 = 260,000
The add-on is often quoted as a separate increment
to the contract.

Lease Rates
 Sometimes, lease rate is quoted as a certain
percentage of original cost per month.
For example, 2% of the cost of equipment per month
is approximately equal to 5% add-on).
For an asset of Taka 200,000, monthly rent = Taka
4,000
When the lessee has high credit rating, lease
agreement may be written on a simple interest basis.
 Companies with substantial taxable income
sometimes enter into leasing business to get
depreciation and investment tax credit.

Lease Rates
 As a result, interest rate charged in leasing may
be below the rates for long-term loans.
- However, the lessee is giving up the tax benefits
arising from depreciation.
 So, leasing is primarily advantageous for a
lessee who is unable to use depreciation deductions
and investment tax credits.

Reserve and Setup Charge
Lessee required to put up a lease deposit equal to
first and last month’s rent (lease payment) for each
year of the contract life.
If lenient, lessor might charge 2 months’ rent + setup
charge or security deposit.

TAX ASPECT OF LEASING
To determine the type and character of tax
deductions, a lessee must determine whether the
lease agreement is a true lease or a conditional
sales contract.
- If the agreement is a true lease, the lessee may
deduct rental payments for tax purpose.
If the agreement is a conditional sales contract the
payments will be considered payments for the
purpose of acquiring the property and deductions will
be allowed for depreciation and possibly interest
expense.

Conditional Sales Contract
A lease agreement is called conditional sales
contract if it meets any of the following conditions.
1. Portions of the periodic payments are
specifically applicable to an equity to be
acquired by the lessee.
2. Title will be acquired upon payment of a stated
amount of rentals.
3. The total payments required for a relatively short
period of use constitute an excessively large
fraction of the total amount required for having
the title of the asset.

4. The agreed rental payments materially exceed
the current fair market rental value for the same
asset.
5. The property may be acquired under a purchase
option
or the price is relatively small when compared to the
total payments the lessee is required to make.
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6. Some portion of the periodic payment is
specifically designated as interest or is
otherwise readily recognizable as the equivalent
of interest.
7. Title will be acquired on payment of aggregate
amount that approximates the initial sales price,
plus interest and carrying charges at which the
lessee could have purchased the equipment
when entered into the agreement.
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Leveraged Leases
Leveraged leases involve three parties – lessor, lessee
and a lender to the lessor. Usually these leases are
financial leases (Lessee covering maintenance,
insurance and taxes).
• Lease term covers a large portion of the useful life of
the leased property.
• Lessee’s payments to the lessor are sufficient to
discharge the lessor’s payments to the lender.

Bona Fide Lease Transactions
1. The term should be less than 30 years,
otherwise the lease may be regarded as a form
of sale.
2. The rent should represent a reasonable return to
the lessor.
3. The renewal option should be bona fide.
4. There should be no purchase option, or if there
is one, the lessee should merely be given parity
with an equal outside offer.

LEASING VS. OWNERSHIP
There are three major alternatives to finance an
asset:
1. A lease agreement
2. An installment sales contract
3. A term loan secured by a mortgage

LEASING VS. OWNERSHIP
Total advantage to be derived from an alternative
depends on:
1. interest expense,
2. depreciation,
3. investment tax credit
4. time value of money
5. potential capital gain due to higher salvage
value.
Nevertheless, in many cases, the advantages of
leasing may outweigh ownership.

Cost of Capital Tied up in Purchase
In other techniques of financing an asset may cost
less than leasing, but capital is tied up in property
acquisition.
For a growth company, any money freed by leasing
(instead of purchasing) may earn a high rate of
return.

Balance Sheet Implications of Leasing
Two possibilities exist to maximize financial leverage
through leasing under operating leases:
1. It is possible for firms to obtain more money for
longer terms under a lease agreement than
under a secured loan agreement for the
acquisition of the asset.
2. Leasing may not have as much of an impact on
future borrowing as would current borrowing.

Balance Sheet Implications of Leasing
Firm X -Purchase
Assets Capital & Liabilities
Before After Before After
Assets 200 300 Debt
Equity
100
100
200
100
Total 200 300 200 300
Firm X -Firm Y - Lease
Assets Capital & Liabilities
Before After Before After
Assets 200 200 Debt
Equity
100
100
100
100
Total 200 200 200 100

Accounting for Leases: Lessee’s Standpoint
Leases treated in 2 ways
1. Capital Leases i.e. purchase of assets
2. Operating Leases (all other leases)

Criteria for Capital Lease
• Transfer of ownership at the end of term
• Lease contract contains a bargain purchase option
(price < fair market value at option date)
• Term is >= 75% estimated economic life of
property
• {PV of lease payments- executor costs}>= 90% of
the excess of fair value of the leased property

Issues Relating To Accounting For Leases
Fair Value:
• Fair value is defined as the price for which
property could be sold in an arm’s-length
transaction between unrelated parties.
• It is the normal selling price (less discount) of a
manufacturer/dealer and cost for the non-
manufacturer/non-dealer.
• It is determined at the inception of the lease.

• The estimation of fair value is important because:
- It is needed to calculate interest rate implicit
in the lease, residual value, bargain renewal
option, bargain purchase option.
- Fair value becomes the upper limit on the
amount the lessee may record as an asset for
a capital lease.

Economic Life:
• The economic life of a property is defined as the
estimated remaining period during which the
property is expected to be economically usable, by
one or more users, with normal repairs and
maintenance.
• The estimation of economic life is important
because it is one of the criteria used to classify
lease. Also it has an impact on the residual value.

• The economic life of the leased property is limited
by the use for which it was intended at the
inception of the lease. (Number of users is not
important.)

Residual Value:
• The residual value of the leased property is the
estimated fair value of the property at the end of
the lease term.
• Lessee requires the residual value to determine
the implied interest rate.
• Lessor records the estimated residual value as
part of its gross investment in the lease.

• Sometimes, residual value is difficult to estimate
because of the unpredictability of future events.
 As a result, interest rate charged in leasing
may be below the rates for long-term loans.
- However, the lessee is giving up the tax
benefits arising from depreciation.
 Leasing is primarily advantageous for a
lessee who is unable to use depreciation
deductions and investment tax credits.

TAX ASPECTS OF LEASING
• Tax requirements differ from financial reporting
requirements.
• When the intended lease is treated as a true lease
for tax purpose, the lessor reports the rental
income from lease and the lessee get tax
advantage for the rental payment.

• If a lease is treated as a sale, the buyer (lessee) is
entitled to get tax deduction for depreciation
expense and interest expense.
- The depreciation expense will be computed
over the useful life of the asset, not over the
lease term.
- The lessee’s basis for depreciation is the sum
of all amounts that represent a part of the
purchase price.

• When the lease is treated as a conditional sale,
the lessee is entitled to get investment tax credit.
If a conditional sale is deemed to have occurred:
- Lessor must show any gain realized on the
sale
- Required to report interest income,
- Not entitled to a deduction for depreciation.

Tax Effects of a Sale and Leaseback:
• Because funds are tied up in ownership of assets, a
firm may decide to sell the property and lease it
back.
• Also, some people may place the property in trust for
his/ her children and lease it back. This is called gift
and leaseback.

Criteria for Tax Advantage
Sale and leaseback or gift and leaseback may provide
some tax advantages. These transactions will not be
recognized if these are done for tax avoidance. Three
criteria have been employed in making this
determination:
a. Lack of Equity Interest: The taxpayer cannot
hold title or equitable interest in the property.
Keeping a reversionary interest has been
construed to represent an equity interest.

Criteria for Tax Advantage
b. Business Purpose: A business purpose must be
present, with the sale being grounded in economic
reality. Whether the rent paid is reasonable, is
considered in determining a legitimate business
transaction.
c. Independent Trustee: In assessing the good faith
of a gift to a trust and subsequent leaseback, the
independence of trustee is a crucial factor. Tax
deductions will not be allowed if the control
remains in the hands of the donor.

Conditions that must be fulfilled
to treat leveraged lease as a true
lease:
1. Minimum At-Risk Investment
The lessor must have a minimum at risk investment
in the property and that will continue from the
beginning through the end of the lease term.
2. No Bargain Purchase Option
No member of the lessee group may have a
contractual right to purchase the property at less
than the fair market value.

Conditions that must be fulfilled
to treat leveraged lease as a true
lease:
3. No Investment/Lending by Lessee Group
No member of the lessee group can invest in the
property or lend money to the lessor towards the
purchase.
4. Profit Motive
Lessor must expect a profit from the transaction
apart from any tax advantages.

Leasing

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