Important Chapter Terms

• Asset-based lending • Operating lease

• Captive finance • Sale and leaseback
companies
(SLB) agreement
• Secured financing
• Financial lease
• Small and medium-
• Lessee sized enterprises
• Lessor (SMEs)
• Leveraged lease
• Off-balance-sheet
financing
CHAPTER 16 – Leasing 16 - 2
 Leasing Arrangements
Introduction

• The decision to invest in an asset that has a long life is a

capital budgeting decision.
• The decision to acquire is a separate decision from the
decision on the method of financing the acquisition
• When these two decisions are combined, this is called
asset-based lending because the financing is tied directly to
a particular asset.
• Examples of asset-based lending include:
– Secured loans
– Conditional sales contracts
– Leases

CHAPTER 16 – Leasing 16 - 3
 Leasing Arrangements
The Institutional Framework
• Canadian Finance and Leasing Association (CFLA)
acts as the trade association for asset-based lenders
– 160 members
– Represents three group of financial companies:
1. Independent asset-based finance companies
– Involved in machinery and equipment financing with 60% of customers begin
SMEs.
– 40% of the assets financed are transportation equipment (buses, trucks, trailers
or office equipment)
2. Captive finance companies of major manufacturers (eg. GMC
Finance and Ford Credit Canada) where 1/3 of all new vehicles
are leased.
3. Chartered banks
– Chartered banks are not allowed to lease consumer household property and
are therefore focussed on leasing commercial transportation equipment and
real property such as land and buildings

CHAPTER 16 – Leasing 16 - 4
 Lease
What is it?

A lease contract is an agreement where the

owner conveys to the user the right to use an
asset in return for a number of specified
payments over an agreed period of time
Lessor is the owner of the asset
Lessee is the user of the asset

CHAPTER 16 – Leasing 16 - 5
 Leasing
Types of Leases

Operating Lease
• A lease where some of the benefits of ownership do not
transfer to the lessee and remain with the lessor.

Financial (Capital) Lease

• A lease where essentially all the benefits of ownership
transfer to the lessee; also known as a capital or full
payout lease.

(See Table 16-1 on the following slide for the distinguishing features between the
two types of leases)

CHAPTER 16 – Leasing 16 - 6
 Types of Leases
Operating versus Financial Leases
Table 16-1 Operating versus Financial Leases

OPERATING FINANCIAL

Lessee Lessor Lessee Lessor

Asset Not on balance Report on B/S Report on B/S Not on B/S
sheet (B/S);
disclos e in
footnotes
Lease payments Expense the Claim as rental Decom pose Claim the
full am ount as incom e into interest interest portion
rental expense and principal of paym ents
repaym ent, and received as
expense the interest incom e
interest portion
Depreciation Cannot claim Claim Claim Cannot claim
expense
(associated with
leased asset)

CHAPTER 16 – Leasing 16 - 7
Conditional Sales Agreement
What is it? CRA Perspective
According to Canada Revenue Agency (CRA) a conditional
sales agreement exists if one of the following occurs:
• The lessee automatically acquires ownership at some point
• The lessee is required to buy the asset at some point or guarantee that
the lessor gets a certain value for it
• The lessee has the right to buy the asset at some point for substantially
less than the likely fair market value
• The lessee has the right to buy the asset at a price that would cause a
reasonable person to conclude that they will buy it.

CRA’s interest in this issue is that it must determine which party

to the contract has the legal right to claim CCA for tax purposes.
If any of the other above conditions are satisfied, CRA regards
the user (lessee) as having the right to claim CCA.

CHAPTER 16 – Leasing 16 - 8
Financial/Capital/Full Payout
Lease
What is it? Accounting Perspective
According to the Canadian Institute of Chartered Accountants
(CICA), all of the benefits of ownership transfer to the lessee
with these lease agreements.

The lessee is deemed to own the asset and will claim

depreciation on the firm’s income statement and record the
value as an asset and liability on the balance sheet.

Such leases usually:

• Require the lessee to carry out maintenance and insure the asset
• Provides the lessee with a fixed purchase option
• The lease agreement covers 75% of the economic life of the asset
• Is structured so that the present value of lease payments exceeds 90 %
of the cost
• Involves fixed rental payments.

CHAPTER 16 – Leasing 16 - 9
 Operating Lease
What is it? Accounting Perspective

• If a lease is NOT a capital lease, then it is an

operating lease
• Operating leases do not transfer to the lessee
the benefits of ownership (ability to deduct
CCA)

CHAPTER 16 – Leasing 16 - 10
Sale and Leaseback Agreement
What is it?
• An agreement in which the owner of an asset sells
it to another party and then leases the asset back
• Popular type of lease for organizations in low tax
brackets because they are unable to use the tax
shield offered by CCA
• SLBs can mean that part of the tax savings can be
transferred back to the seller in the form of lower
lease payments, reducing the cost of the asset
• 1989 federal budget significantly reduced the
benefits from such agreements by forcing the lessor
to deduct depreciation on leased assets only from
income derived from leasing.
CHAPTER 16 – Leasing 16 - 11
 Leveraged Lease
What is it?

• A three-way agreement among the lessee, the

lessor, and a third party lender in which the lessor
buys the asset with only a small down payment and
the lender supplies the financing
• Popular in U.S. because lessor puts up only a
portion of the asset purchase price, but receives all
of the tax benefits of ownership
• Not popular in Canada because CRA restricts use of
CCA to the party at risk, and CCA deductions cannot
be carried over to offset taxes on other income

CHAPTER 16 – Leasing 16 - 12
 Accounting for Leases
Accounting for Leases
• Financial leases are included on the
balance sheet of the lessee
– Present value of all lease payments is recorded
on the right-hand side of the balance sheet
– The same amount is recorded as an asset on
the left-hand side of the balance
• Operating leases are off-balance-sheet
financing for the lessee (included only in the
notes to the financial statements)
CHAPTER 16 – Leasing 16 - 13
 Accounting for Leases
Financial Statement Effects of Lease
Classification
Capital/Financial/Full Payout Leases:
Income Effects
1. Net income will generally be lower for capital leases in the
early years and higher in the later years.
2. CFO will be higher with capital leases. CCA may be deducted
in measuring Net Income after tax, however, CCA is added
back when determining CFO. Capital/ financial leases expense
only the interest portion of the payments in determining EBT.
Balance Sheet Effects
1. Lower current ratios, higher debt and leverage ratios, lower
asset turnover and lower profitability ratios (especially in the
early years of asset life)

CHAPTER 16 – Leasing 16 - 14
 Accounting for Leases
Financial Statement Effects of Lease
Classification
Operating Leases:
Income Effects
1. Net income will generally be higher for operating leases in the
early years and lower in the later years because interest
expense charged for the financial lease declines as the liability
is amortized by the lease payments.
2. CFO will be lower with operating leases since the full lease
payment is subtracted from CFO, unlike financial leases where
only the interest portion of the payments is subtracted.
Balance Sheet Effects
1. Higher current ratios, lower debt and leverage ratios, higher
asset turnover and higher profitability ratios (especially in the
early years of asset life)
CHAPTER 16 – Leasing 16 - 15
 Evaluating the Lease Decision
Lease Versus Buy
• Leasing is an alternative means of obtaining the use of an
asset
• There are four main differences in the cash flows for a
company that leases an asset instead of buying it:
1. It does not have to pay for the asset up front
2. It does not get to sell the asset when it is finished with it, if it is an
operating lease, or if title is not transferred through a financial
lease
3. It makes regular lease payments. If the lease is an operating
lease, then the full amount of the lease payments is tax
deductible; only the interest portion is deductible for capital
leases
4. Operating leases are not depreciated.
CHAPTER 16 – Leasing 16 - 16
 Evaluating the Lease Decision
Lease Versus Buy Evaluative Frameworks
IRR of Leasing Analysis
– Estimate incremental cash flows that result from
leasing
– Solve for the discount rate (IRR) that equates the
incremental cash flows with the initial value of the
asset. (This is the after-tax IRR or cost of leasing)
• If IRR of leasing > after-tax cost of borrowing (borrow
and buy the asset)
• If IRR of leasing < after-tax cost of borrowing (lease the
asset)

CHAPTER 16 – Leasing 16 - 17
 Evaluating the Lease Decision
Lease Versus Buy Evaluative Frameworks

NPV of Leasing Analysis

– Estimate incremental cash flows that result
from leasing
– Calculate NPV using after-tax cost of
borrowing as the discount rate.
• If NPV of leasing is – (borrow and buy the asset)
• If NPV of leasing + after-tax cost of borrowing
(lease the asset)
CHAPTER 16 – Leasing 16 - 18
 Motivation for Leasing

1. Cheaper financing (which party can make better

use of the CCA tax shield/)
2. Reduce the risks of asset ownership
3. Implicit interest rates
4. Maintenance
5. Convenience
6. Flexibility
7. Capital budgeting restrictions
8. Financial statement effects
CHAPTER 16 – Leasing 16 - 19
 Summary and Conclusions

In this chapter you have learned:

– That firms can gain the use of assets through
leasing rather than outright ownership
– The general differences between operating
and financial leases
– How to evaluate a potential lease decision
using discounted cash flow analysis
– The various reasons firms might have for
entering into lease arrangements
CHAPTER 16 – Leasing 16 - 20