Foundations of Financial Management: An Analysis (part 63)

Being rich is having money; being wealthy is having time.

— Margaret Bonanno

Long-Term Debt and Lease Financing

(Part B)

by

Charles Lamson

Leasing as a Form of Debt

When a corporation contracts to lease an oil tanker or a computer and signs a non-cancelable, long-term agreement, the transaction has all the characteristics of a debt obligation. Long-term leasing was not recognized as a debt obligation in the early post-world War II period, but since the mid-sixties there has been a strong movement by the accounting profession to force companies to fully divulge all information about leasing obligations and to indicate the equivalent debt characteristics.

This position was made official for financial reporting purposes as a result of Statement of Financial Accounting Standards (SFAS) No. 13, issued by the Financial Accounting Standards Board (FASB) in November 1976. This statement said certain types of leases must be shown as long-term obligations on the financial statements of the firm. Before SFAS No. 13, lease obligations could merely be divulged in footnotes to financial statements, and large lease obligations did not have to be included in the debt structure (except for the upcoming payment). Consider the case of firm ABC, whose balance sheet is shown in Table 7.

Table 7 Balance sheet ($ millions)

Before the issuance of SFAS No. 13, a footnote to the financial statements might have indicated a lease obligation of $12 million a year for the next 15 years, with a present value of $100 million. With the issuance of SFAS No. 13, this information was moved directly to the balance sheet, as indicated in Table 8.

Table 8 Revised balance sheet ($ millions)

We see that both a new asset and a new liability have been created, as indicated by the asterisks. The essence of this treatment is that a long-term, noncancelable lease is tantamount to purchasing the asset with borrowed funds, and this should be reflected on the balance sheet. Between the original balance sheet (Table 7) and the revised balance sheet (Table 8), the total-debt-to-total-assets ratio has gone from 50 percent to 66.7 percent.

Though this represents a substantial increase in the ratio, the impact on the firm's credit rating or stock price may be minimal. To the extent that the financial markets are efficient, the information was already known by analysts who took the data from footnotes or other sources and made their own adjustments. Nevertheless, corporate financial officers fought long, hard, and unsuccessfully to keep the lease obligation off the balance sheet. They tend to be much less convinced about the efficiency of the marketplace.

Capital Lease versus Operating Lease

Not all leases must be capitalized (present-valued) and placed on the balance sheet. This treatment is necessary only when substantially all the benefits and risks of ownership are transferred in a lease. Under these circumstances, we have a capital lease (also referred to as a financing lease). Identification as a capital lease and the attendant financial treatment are required whenever any one of the four following conditions is present:

1. The arrangement transfers ownership of the property to the lessee (the leasing party) by the end of the lease term.

2.  The lease contains a bargain purchase price at the end of the lease. The option price will have to be sufficiently low so exercise of the option appears reasonably certain.

3.  The lease term is equal to 75 percent or more of the estimated life of the leased property.

4.  The present value of the minimum lease payments equals 90 percent or more of the fair value of the leased property at the inception of the lease.

A lease that does not meet any of these four criteria is not regarded as a capital lease but as an operating lease. An operating lease is usually short-term and is often cancelable at the option of the lessee. Furthermore, the lessor (the owner of the asset) may provide for the maintenance and upkeep of the asset, since he or she is likely to get it back. An operating lease does not require the capitalization, or presentation, of the full obligation on the balance sheet. Operating leases are used most frequently with such assets as automobiles and office equipment, while capital leases are used with oil drilling equipment, airplanes and rail equipment, certain forms of real estate, and other long-term assets. The greatest volume of leasing obligations is represented by capital leases.

Income Statement Effect

The capital lease calls not only for present-valuing the lease obligation on the balance sheet but also for treating the arrangement for income statement purposes as if it were somewhat similar to a purchase-borrowing arrangement. Thus, under a capital lease, the intangible asset account previously shown in Table 8 as "Leased property under capital lease"is amortized, or written off, over the life of the lease with an annual expense deduction. Also, the liability account shown in Table 8 as "Obligation under capital lease" is written off through regular amortization, with an implied interest expense on the remaining balance. Thus, for financial reporting purposes the annual deductions are amortization of the asset, plus the implied interest expense on the remaining present value of the liability. Though the actual development of these values and accounting rules is best deferred to an accounting course, the finance student should understand the close similarity between a capital lease and borrowing to purchase an asset, for financial reporting purposes. 

An operating lease, on the other hand, usually calls for an annual expense deduction equal to the lease payment, with no specific amortization, as is indicated in the next post, "Lease versus Purchase Decision."

Advantages of Leasing

Why is leasing so popular? It has emerged as a trillion dollar industry. Major reasons for the popularity of leasing include the following:

1. The lessee may lack sufficient funds or the credit capability to purchase the asset from a manufacturer, who is willing, however, to accept a lease arrangement or to arrange a lease obligation with a third party.

2.  The provisions of the lease obligation may be substantially less restrictive than those of a bond indenture.

3.  There may be no down payment requirement, as would generally be the case in the purchase of an asset (leasing allows for a larger indirect loan).

4.  The lessor may possess particular expertise in a given industry allowing for expert product selection, maintenance, and eventual resale. Through this process, the negative effects of obsolescence may be reduced.

5.  Creditor claims on certain types of leases, such as real estate, are restricted in bankruptcy and reorganization proceedings. Leases on chattels (non-real estate items) have no such limitation.

There are also some tax factors to be considered. Where one party to a lease is in a higher tax bracket than the other party, certain tax advantages, such as depreciation write-off or research related tax credits, may be better utilized. For example, a wealthy party may purchase an asset for tax purposes, then lease the asset to another party in a lower tax bracket for actual use. Also, lease payments on the use of land are tax-deductible, whereas land ownership does not allow a similar deduction for depreciation. It should be pointed out that tax advantages related to leasing were reduced somewhat with the passage of the Tax Reform Act of 1986.

Finally, a firm may wish to engage in a sale-leaseback arrangement, in which assets already owned by the lessee are sold to the lessor and then leased back. This process provides the lessee with an infusion of capital, while allowing the lessee to continue to use the asset. Even though the dollar costs of a leasing arrangement are often higher than the dollar costs of owning an asset, the advantages cited above may outweigh the direct cost factors. 

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 483-486*

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