The Different Types of Leases - Research Paper Example

Lease financing, the different types of leases, tax effects, evaluation by the lessee and evaluation by the lessor and other reasons for leasing. Contents Introduction 3 Research objectives 3 Literature Review 3 Conclusion 9 Reference 10 Introduction Flexibility makes leasing an attractive and effective form of financing. This is the reason why almost one-third of financial acquisitions at the present times take places through leases. Presently over 90% of the companies have recognized leasing as the alternative to financing. They involve in making plans to lease in the near future. Research objectives The research paper will try to analyze the different types of leasing and the effects of the leasing on the lessor and lessee. Literature Review In order to obtain business equipment and supplies that can shed its effects on the flow of money, one can rely upon lease financing as the possible way to straight up capital. Recent surveys prompt that more than 80% of the business organizations in the United States rely on this alternative at minimum one of the equipment acquisitions. It is forecasted that almost 95% would lease in the future. Lease financing is often referred to as “lease”. (Lee, 2003, p. 8). It is a contractual agreement involving two parties the lessor and lessee. The lease can be defined as a legal document that must be reviewed by an experienced attorney. The company acts as the lessor grants the individual or group acting as the lessee leasing the product or equipment. The contract assigns the lessee to operate the equipment for some pre specified time. In the period the lessee is required to make monthly payments to the lessor for providing the opportunity. Lease can be categorized into the following: lease of finance and lease of operation, sale and lease back along with direct lease, lease of single investor and leveraged lease, domestic lease and international lease (FLA, n.d.). However finance lease and operating lease are the most popular leases. A financial lease covers the entire life of the equipment to be leased. A sale and lease can be thought of as one type of financial lease. One can even think of combination lease. This type of lease combines aspects of the popular leases (Auburn University, n.d. p. 1). The effects of the tax can be categorized in the following two ways. The first category is to determine the effects of each flow of cash on taxable income. Rents or other type of fees tend to increase the taxable income while expenditure has the opposite effect. The second category is to compute the amount of the tax to be paid and time when the payment is to be made. After the calculation of the taxable income the rate of the tax is applied to arrive at the liability. The tax is generally paid with 4 installments. The fourth, sixth, ninth and the twelfth month is regarded as the months of payment for the particular year. The amount of the flows is referred as magnitude. One needs to determine the timing of the flows. It is easy to calculate the cash flows before tax but it may not so easy to calculate the cash flows caused by taxes. At this moment it is just not sufficient to find out the payment to the IRS. The timing of the payment and credits are to be taken into consideration. An entity that is leased will want to find out the value of inflows and outflows. The business activity of all business shapes will be encompassed on the payments made to the IRS. The flow of cash before tax is exposed to credit and default risks. The flow of cash due to tax is exposed to modifications in the laws of tax. In true leases the provisions of a certain company allow 200% of the residual basis of an asset. This is written off over the depreciable life of an asset under consideration. Suppose the cost of equipment is 1,000,000 dollars. The term of the contract is 10 years. There are 40 quarterly payments in arrears amounting to 30,392.32 dollars. The life of the chosen company is 7 years and the rate of tax is 35%. The residual allowed is 20%. Some proportion of the benefits from taxation is passed on to the lessee. This may take the form of lower lease rate. The pre tax cash flow is assumed to be constant in the analysis. These assumptions would create a nominal pre-tax 8% MISF yield when it is represented as a lease. However these assumptions will produce an interest rate of 6.37% and yield when structured as a loan (Holmgren, n.d. p. 1). The point of view of the lessee is taken into consideration first. The operating lease will have no effect on the balance sheet because the method does not require creation of any asset or liabilities. When the finance lease is recorded, a leased asset and an obligation are created. In the course of the life of the lease the obligation and the asset are written off. But a net liability is created as the assets are written down faster than the liability. In the income statement the operating lease payment is considered as an expense. But these types of payments are generally stable over the lease period. In finance lease both expenses on interest and depreciation are created in the income statement. Under the operating method the expenses combine to produce larger expense than reported. But this usually happens in the initial years of the lease. The trend in total expense declines over the period and produces positive earnings. The total lease spending is same for both methods in the entire term period. The entire outflow of cash are recorded as operating flow of cash in operating lease while in finance leasing the cash outflow is distributed in interest payments and the remaining in principal lease repayment. The profit margins are higher in the initial years under operating lease but lower for finance lease. The asset turnover and the current ratio are higher for operating lease and lower in case of finance lease. The debt to equity ratio is lower in case of operating lease and higher in case of finance lease. The interst coverage is generally higher in operating cash flow as there is no spending of interest under this method. The interest coverage is likely to be lower in finance lease as spending on interest is created by the finance. The interest coverage ratio rises over the course of time as spending on interest declines. The view point of the lessor is taken into consideration now. The operating lease or the finance lease will have no effect on the balance sheet as assets are not recorded and investment in lease asset is equal to reduction in PPE. The operating lease will also have no effect on income in the period of the lease as gains from sales go unrecognized. The effect of finance lease on the income is higher than the operating lease as lessor has the potential to recognize the profits in sale. The operating cash flow will not be able to shed its effects on operating cash flow as cash do not change hands on initiation. The finance lease will have no impact as well because of the same reason. The method of leasing provides the opportunity of 100% financing. Expenses on services like shipping, installation and engineering can be included in the financing. There is uncertainty of interest rates. So it is profitable for the organizations to look out for long term expenses at the current price. Leasing provides such opportunities to the organizations. Leasing also protects the prevailing lines of credit. Businesses in the starting phases require credit flows. By following the leasing method it can diversify the lending relationships which provide maximum chance to access the required credit. Leasing provides advantages in tax. This is an attractive advantage for business which is subjected to other Minimum Tax. In some cases total write off of lease payment is provided. Leasing is not subjected to time constraint. Delays in acquisition of equipment can be nullified by leasing. If budget plans on a part of the year is made and some purchase plans were not included in advance then sufficient time of financing can be saved. Leasing provides flexibility in structure of repayment. Some business tends to earn cash in some specific time in the year. Leasing helps to diversify the repayment. Business can easily plan the repayment period to match with the time of cash flow. Lease structure also includes options to skip payments or deferred payments. Companies are of the opinion that possession by leasing is more popular than usual purchase. Conclusion The distinction between operating and financial lease is important to achieve any decisions on financial accounting. The balance sheet reflects the financial leases while the operating leases are ignored. Another important determinant in leasing is tax. Tax plays a major role in the effects of a lease. Different tax rules can present the structure of the lease in attractive fashion. Lease has the ability to rule out the uncertainty surrounding the remaining value of the asset that is leased. Reference Lee, S. (2003). Capital and operating leases. Retrieved From: http://www.fasab.gov/pdffiles/combinedleasev4.pdf. Auburn University. (n.d.). Lease Financing. Retrieved from: http://www.business.auburn.edu/~pagedan/ch20sol.pdf. FLA. (n.d.). Types of Leasing. Retrieved From: http://www.fla.org.uk/business/types-of-leasing Holmgren, D. (n.d.). Quantifying the effects of tax on leasing. Retrieved From: http://www.ivorycc.com/media/files/Quantifying%20the%20Tax%20Effects%20of%20Leasing.pdf Read More