SEDE NORTE DEL CAUCA READING ACCOUNTING TEXTS

SANTANDER DE QUILICHAO LEVEL III

PUBLIC ACCOUNTANCY PROF. ANDRÉS FELIPE MOLINA M
SEM. 05

NAME…………………………………………………… CODE……………………DATE ………….

LEASING.

Virtually any asset that can be purchased can also be leased. A lease is a contract between the
owner of an asset, called the lessor, and another party, called the lessee, who makes periodic
payments to the owner for the right to use the asset. From the introduction of leasing by
Phoenician ship-owners 3000 years ago until the mid-1960s, only a few types of assets could
be leased and the volume of lease transactions was not very large compared with the volume of
purchases. However, in recent years the volume of leasing and the range of assets available for
lease have grown dramatically. In addition to the well-established leasing operations in
computers, office equipment, transportation equipment (railroad cars, autos, aircraft, ships), and
machinery, leasing arrangements now extend to such areas as shipping containers, nuclear fuel
cores, medical equipment, and pollution control devices. Approximately one-fifth of all new
equipment in the United States is leased. A striking example of the importance of leasing is
Anaconda Aluminum's $138,000,000 reduction mill near Sebree, Kentucky, which is entirely
leased. That single plant represents approximately 3 percent of the entire United States
aluminum production capacity. Even the United States Navy began leasing ships in 1971 when
Congress failed to appropriate funds for the purchase of needed fuel tankers. Leasing, indeed,
has come of age.

WHO PROVIDES LEASING?

As we noted, at least two parties are involved in a lease –the lessor (owner) and the lessee
(user). In a leveraged lease, there is also a lender (for example, an insurance company), from
whom the lessor borrows the funds to purchase the assets. Sometimes, a lease packager or
an investment bank will arrange the lease agreement for a fee without participating directly as a
lessor, lessee, or lender. In terms of dollar volume, the most important lessors of equipment are
the manufacturers themselves; they represent roughly half the equipment leasing done in the
United States. Banks account for approximately one-third of the equipment leasing, with most of
the rest done by independent leasing companies.

TYPES OF LEASES

Operating Lease. An operating lease is a short-term lease (lease term is only a small fraction
of the useful life of the asset). A long-term lease which allows the lessee (and sometimes the
lessor) to cancel the lease at any time is also referred to as an operating lease. The lessor may
provide services under the lease agreement such as maintenance, insurance, and the payment
of property taxes. Vehicles, computers, copiers, amusement equipment, display fixtures, and
furniture are among the assets commonly required on an operating lease basis. The term
“operating lease” also refers to a lease which is not classified under accounting rules as a
capital lease.
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Financial Lease. A financial lease (or finance lease) involves an intermediate or long-term
commitment by the lessor and lessee. If the asset is equipment, the lease duration will generally
equal at least half of the expected useful life of the assets. Maintenance or other services are
not generally provided by the lessor under a financial lease although this is subject to
negotiation.
Assets often covered by financial leases include real estate, office equipment, medical
equipment, railroad cars, airplanes, and construction equipment. If the asset is real estate, the
lessor may be an individual or a business firm, frequently an insurance company. An equipment
lessor is commonly a manufacturer, a finance or leasing company, or a commercial bank. A
common procedure for leasing equipment is for the lessee to determine the equipment it wants
to lease and to settle on a purchase price with the manufacturer. The firm then finds a leasing
company or bank, which will purchase the asset and lease it to the firm for a rental which
provides an adequate return on the lessor’s investment.

A financial lease will often provide a means for the lessee to continue possession of the
property after the expiration of the initial lease. This may be allowed for under a renewal option
that permits the lessee to obtain a new lease at a specified rental after the initial lease expires.

The lease may also contain a purchase option that gives the lessee the right to buy the asset for
a particular price at the lease’s expiration.
The lease payment is a fixed obligation of the lessee and, as with debt interest, failure to
make the rental payment can result in insolvency and bankruptcy court action. Although the
lessor’s claim against the lessee in the event of bankruptcy is usually somewhat less stringent
than that of most creditors, it does provide for repossession of the leased asset and at least
partial payment to the lessor of lease rentals applicable to the remaining term of the lease.
Perhaps more relevant is that, for the going concern, leases involve a fixed charge like debt
payments, and therefore fluctuations in firm income are absorbed by the lessee. In other words,
a financial lease, like debt, involves the benefits and dangers of leverage.

Sale and Leaseback. A firm may sell an asset it already owns to another party and then lease
it back from the buyer. In this way the firm can obtain cash (proceeds from the sale) and still
have use of the asset. This arrangement is called a sale and leaseback. Financial leases
(rather than operating leases) are virtually always used in sale and leasebacks. The lease will
ordinarily provide for an option either to renew the lease or to purchase the asset at the end of
the lease term.
As with an ordinary financial lease, the buyer and lessor under a sale and leaseback
agreement will frequently be an insurance company if the asset is real estate, or a leasing firm,
finance company, or commercial bank if the asset is equipment. The lease provisions are the
same as those described for financial leases in general.

Full-Service Lease. Under a full-service lease the lessor maintains and insures the assets and
pays property taxes on the asset. This is similar to a maintenance lease, which obligates the
lessor to provide maintenance services. A full-service lease is the opposite of a net lease,
under which the rent payment is “net,” i.e., the lessee pays maintenance costs, insurance, and
property taxes.
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Leveraged Lease. A leverage lease, or third-party lease, involves a third party –a lender— in
addition to the lessor and lessee. The lessor borrows part of the asset’s purchase price from the
lender, and the lease rentals are used to service the loan, any excess going to the lessor. Both
the depreciation (for tax purposes) and the investment tax credit on the asset are allocated to
the lessor. The loan is on a nonrecourse basis, i.e., the lender has a claim against the asset and
the lease rentals if there is default on the loan but the lender may not demand additional
payments from the lessor. Therefore, even in the unlikely event that the asset becomes
worthless and the lessee becomes bankrupt, the most that the lessor could lose would be the
down payment that it made in purchasing the asset. Of course, the loan will carry an interest
rate which adequately compensates the lender for the risks involved.