Who generally are the lessors that own lease

properties? (3)

                 1. Banks

                 2. Captive leasing companies

                 3. Independents

Who are the largest players in

the leasing business?

Banks.

They have low-cost funds*, which give them the advantage of being able to purchase assets at less cost than their competitors.

They have decided that there is money to be made in leasing, and as a result they have expanded their product lines in this area.

Finally, leasing transactions are now more standardized*, which gives banks an advantage because they do not have to be as innovative in structuring lease arrangements.

*- advantage

What are Captive Leasing Companies?

Subsidiaries whose primary business is to perform leasing operations for theparent company.

Ex: Suppose that Serling Constr. wants to acquire a number of earthmovers from *Caterpiller. 

In this case, Caterpillar Corp. will offer to structure the transaction as a lease rather than as a purchase. 

Thus Caterpillar Financial provides the financing itself  internally rather find an outside company

* - denotes Captive Leasing Company

Advantage for Captive Leasing Companies

Point-of-Sale Advantage

When these companies receive a possible order, its leasing subsidiary can quickly develop a lease-financing  arrangement.  Furthermore, the captive lessor has product knowledge that gives it an advantage when financing the parents' company

Have product knowledge

Gives an advantage when financing the parent’s products

Independents

Points and Disadvantages

• Have not done well over last few years
• Market Share has dropped dramatically as banks and CLC's have become more aggressive in the lease-financing area

Disadvantages:

         1. Don't have point-of-sale access

         2. Don't have Low Cost of Funds Advantage

Advantages of Leasing (6)

            1. 100% Financing at Fixed Rates

            2. Protection Against Obsolescence

            3. Flexibility

            4. Less Costly Financing

            5. Tax Advantages

            6. Off-Balance Sheet Financing

100% Financing at Fixed Rates

Leases are often signed without rquiring any money

down from the lesse.

• This helps the lessee conserve scare cash

Protection Against Obsolescence

Reduces risk of obsolescence for lessee

Tax Advantages

For financial reporting purposes, companies do not have to report an asset or a liability for a lease arrangement.

However companies can capitalize and depreciate the leased asset.

As a result, a company takes deductions

earlier rather than later and also reduces

its taxes -- "synthetic lease" arrangement

Various views on the

Capitalization of Leases

1. Do not Captialize any Leased Assets
2. Captalize Leases That are similar to Insallment Purchases.**
3. Capitalize All Long-Term Leases
4. Capitalize Firm Leases Where the Penalty for Nonperformance is substancial

*FASB agrees with this view.  It notes that Delta should capitalize a lease that transfers substantially all tebenefits and risks of property ownership, provided the lease is noncancelable. 

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More FASB and this one notecard: Conclusions

Conclusions

Viewpoint of FASB regarding Capitalizing Leases that are similar to Installment Packages leads to three conclusions:

1. Companies must identify the characteristics that indicate the transfer of substantially all of the benefits and risks of ownership.

2. The same characteristics should apply consistently to the lessee and the lessor.

3.  Those leases that do not transfer substantially all the benefits and risks of ownership are operating leases.  Companies should not capitalize operating leases. 

• Instead, compies should account for them as rental payments and receipts

Journal Entry

Capitalization of Lease

it records an asset and a liability generally equal to the present value of the rental payments

the following is  a typical journal enty assuming equipment was leased and capitalized.

Journal Entry:

For Lessee:            Leased Equipment    xxx

                                 Lease Liability           xxx

For Lessor:             Lease Receivable     xxx

                                 Equipment                xxx

More Capitalization notes:

How do you jounalize lessee payment?

• Having capitalized the asset, Lessee records depreciation on the leased asset. 

• Both Lessee and Lessor treat the lease rental payments as consisting of interest and principle

• If Lessee does not capitalize the lease, it does not record an asset, nor does lessor.

• When Lessee makes lease payment it records:   

Rental Expense    xxx

   Rental Revenue       xxx

Determining whether lease is a Capital

or Operating Lease

The Criteria?

If you say yes to any of these four criteria, you capitalize the lease. 

1.  Is there a transfer in ownership?

2.  Is there a Bargain Purchase Option?

3.  Is Lease Term >75% of Economic Life?

4.  Is Present Value of Payments>= 90% of

     the fair economic value?

If no to all, it is a operating lease

90% Test

To determine present value you must  know

Minimum Lease Payments

• Minimum Rental Payments
• Guaranteed Residual Value
• Penalty for Failure to Renew or Extend Lease
• Bargain Purchase

Executory Costs

Discount Rates

90% Test

Determining PV and whether it is less than 90%

To determine whether the PV of payments is less than 90 percent of the fair market value, Delta discounts the payments using its incremental borrowing rate.

Determining the incremental borrowing rate often rquires judgement because the lessee bases it on a hypothetical purchase of the property

Exception to rule:

If Delta knows the IMPLICIT RATE OF INTEREST computed by ILFC and it is LESS THAN Delta's INCREMENTAL BORROWING RATE,

then Delta must use ILFC's implicit rate

What is the implicate rate

of interest in a lease

It is is the Discount rate that, when applied to the minimum lease payments and any unguaranteed residual value accruing to the lessor, causes the aggregate PV to = the FV of the leased property to the lessor.

In a capital lease transaction, Delta uses the lease as a source of financing. ILFC finances the transaction through the leased asset.  Delta makes rent payments, which actually are installment payments.  Therefore, over the life of the aircraft rented, the rental payments to ILFC constitute a payment of principal plus interst.

Under Capital Lease Methosd, Delta records the lease as an asset and a liability at: