Corporate Leases - Research Paper Example

Leasing Table of Contents Introduction 1 Lease and Usage of the same as a Financing Vehicle 2 Accounting Lease in the Firm’s Financial Reports 3 Residual Value of a Leased Asset 5 Executory Costs in Leasing 5 Relevant Considerations in a Lease or Sale Decision 6 Discussion of all the Potential Scenarios and the Relevant Accounting Requirements 7 Conclusion 8 Reference 9 Introduction Almost any asset starting from aircrafts to zithers can either be purchased or leased. Leasing is much in vogue among the contemporary organisations. This report deals with the various facet of leasing, its type, costs incurred and the accounting process related to it. Lease and Usage of the same as a Financing Vehicle Leasing is a method of financing property, equipment and plant. Organisations, now, prefer long term financing more than any other methods to finance the equipments. “A lease is a contractual agreement between a lessee and lessor” (Ross et al., 2004, p.593). According to the agreement, a lessee has the right to use an asset and in turn the lessee must make periodic payments to the owner of the assets, the lessor. The lessor is either the manufacturer of the assets or an independent leasing body. As far as the lessee is concerned, the use of asset is more important than ownership of the assets. Corporate leasing can be executed for both short term and long term period. Typically, after deciding on the required asset, the lessee negotiates the contract with the lessor. For a lessee, the process of leasing is quite similar to the one that involves purchasing equipments and assets with secured loan. The terms of a lease contract are often compared with the terms that a banker has to undergo for getting a secured loan. Thus long term leasing is a way to finance the assets. Lease can be seen as renting of capital property. A lease is a long term agreement according to which capital property is rented from one person to another for some fixed period of time at a specified rate. A number of organisations find the leasing more advantageous as this does not require large down payment and helps to control the cash flow in an organisation. Moreover leasing is much easier than getting finance for purchasing the assets. Leasing helps avoid hassles in regards to taxation, depreciation, maintenance, repair responsibilities and enhances asset liquidity. Accounting Lease in the Firm’s Financial Reports A lease must be properly categorised to establish an appropriate accounting treatment. The very act of establishing a proper accounting treatment is to check whether all the risks and benefits of the ownership are considerably transferred to the lessee or not. All the leases that meet the criteria must be capitalised. The lease can be capitalised either through current funds or unexpanded ‘Plant Funds’. As specified earlier, leasing is often considered as the purchase of asset with long term financing. The assets, purchased through lease, are considered as fixed assets at their purchase price. The fixed asset value is gradually written off over the estimated life of the asset. This is done if the leased assets are transferred to the lessee at the end of the lease term. If there is no reasonable certainty that by the end of the lease term the lessee will obtain the ownership, “the asset is fully depreciated over the shorter of the lease term and its useful life” (Lonza, 2005, p.20). The related liabilities are included in the short and long term debt. The finance lease increases the depreciation expense for the depreciable assets as well as raises the fiancé expense for each of the accounting periods. Lease for buildings and lands are treated separately. Operating lease payments are recognised as expenses in the income statement on a straight line basis over the lease term. The financial charge for financial leases is included in the net financial costs. What is the difference between a capital lease and an operating lease? An operating lease is of short term nature. In this case, assets are generally leased for only a part of their useful lives. The lessor takes the risks and rewards of the ownership and is responsible for its insurance and maintenance. When the asset is leased to another lessee, the lessor depends on an asset’s residual value at the end of the lease period. For a lessee point of view the significance of operating lease lies in the following reasons. Maintaining asset may be costly for the firms which do not have much knowledge about the leased equipments. Since the maintenance cost is the liability of the lessor, lessee can save cost on maintenance which includes the cost of having additional staff, keeping adequate inventory of spare parts and maintaining workshop. Certain characteristics of operating lease are as follows. For the period of lease, the lessee pays a periodical rent to the lessor. The lessor takes on the responsibility of repairing, insurance and maintenance. The lessor preserves the risk and rewards the ownership. The lessee uses the assets generally for a period which is less than their useful economic lives. A capital lease allows the transfer of risks and benefits to the lessee. By the end of the term, lease transfers the ownership of the assets to the lessee. The capital lease provides the option of purchasing the leased assets at its bargain price. The term of the lease is equal to or more than 75 % of the estimated economic life of the leased property. In such of kind of leases, the lessee has to take on the costs incurred in repair, maintenance and insurance. As per the financial Accounting Standards Board, apart from the above criteria, capital lease demands one of the either conditions to be met. The lease period is greater than 75 % of the useful life of the equipment. Present value of leasing, excluding the executory cost, equals or goes beyond the fair value of the leased property. Residual Value of a Leased Asset Residual value of any leased asset is the estimated fair value of the asset at the end of the lease term. Residual value of the leased assets can be both guaranteed and unguaranteed. In case of lessee, the guaranteed residual value is that part of the residual value which is guaranteed by the lessee or someone on behalf of the lessee. This means that the guaranteed residual value for the lessee would be the guarantee amount being the maximum amount that could become payable in any event. In case of lessor, the guaranteed residual value is the amount of residual values, guaranteed by or on the behalf of the lessee. The residual value for lessor can also be guaranteed even by an independent third party, who is financially capable of paying off all the obligations as per the guarantee. In other words, guaranteed residual value is the amount that the lessee or a third party agrees to be the value of the leased assets at the end of the lease period. If the asset is worth less than the guaranteed residual value, the lessee or the third party must pay the difference between the guaranteed residual value and the actual value of the asset to the lessor at the end of the lease period. Unguaranteed residual value of any leased asset is the amount by which an asset’s residual value exceeds its guaranteed residual value (Johnson et.al., 2003, p.33.1-33.5). Executory Costs in Leasing The executory cost is the cost incurred when something is leased. The executory cost includes relative expenses such as insurance, maintenance and tax which a lessee may incur while leasing the equipment or property. Executory costs such as insurance and maintenance have a pivotal role in the accounting and reporting for leases. Two recent accounting advancements have profiled the significance of executory costs in classifying lease and determining lessor reported revenues. “The lessor’s requirement to estimate executory costs such as insurance, maintenance, and taxes to be paid by the lessor shall not by itself constitute an ‘important uncertainty’ surrounding the amount of unreimbursable costs yet to be incurred by the lessor under the lease” (ELFA,2004, p. 2). The executory costs should be reported separately as the deduction from minimum lease payments while deriving the ‘net’ minimum lease payments. Relevant Considerations in a Lease or Sale Decision A proper cost benefit analysis must be done while making lease or sell decisions. In case of sale of an asset, the owner can expect a lump sum amount at the time of selling. After selling off the assets, the seller does not have any ownership on the asset. The buyer is responsible for the risks and rewards associated with the assets. Maintenance, insurance and repairing cost are the obligations of the buyer. While leasing, the lessee is required to make periodic payments to the lessor. The cash flow to the lessor is not done immediately; rather it is done in various instalments. Hence, the owner or the manufacturer of the asset is required to evaluate the net present value of the periodic cash flow against the selling value of the asset. If the net present value of estimated periodic cash flow exceeds the sale value of the asset, the owner or manufacturer of the asset will prefer to lease the asset rather than selling it off. While offering lease or selling the assets, the owner must decide on the type of leasing. The evaluation of net present value will depend on the type of leasing. The distribution of risks and rewards would vary in capital and operating leasing. In operating lease, the lessor retains the risks and is rewarded for the assets. This means that the lessor has to bear the repairing, maintenance and insurance cost of the asset. In case of operating lease, all these expenses must be considered while deciding the lease or sale of the asset. The risk is higher in leasing than that in selling. For instance, if the lessee defaults on its payment, the cash flow of the lessor can experience an uncertainty. There is default risk in leasing, which is absent in selling. The reward is higher in leasing, so is the inherent risk. Discussion of all the Potential Scenarios and the Relevant Accounting Requirements Various circumstances can arise from leasing. The accounting procedures would be different for operating and capital leasing. The capitalised value must be equivalent to the cash purchase price as on the inception date of the lease. Any financial costs such as interest must not be included in the value. Capitalisation can be done either through current fund and ‘Unexpended Plant Funds’. The journal entries of the same are done in the following way. a. Initial Entries Budgetary Entry 1. To record the appropriate funds for capital lease Dr. Capital Lease Plant Reserve - XXXX Cr. Capital lease Purchase –XXXX 2. To record the capital lease purchase: Dr. Capital Lease Purchase - XXXX Cr. Capital Lease Plant Reserve –XXXX In the year end entries, the budgetary entries will be reversed by debiting the ‘Capital Lease Purchase’ and crediting ‘Capital Lease Plant Reserve’. To capitalise the value of assets, the asset value will be debited and the investment in plant will be credited. To report the capital lease liability, the investment in plant will be debited and the capital lease liability will be credited. In the year end entries for capital leasing through current funds, the unexpected balances will be debited while the expenditure account will be credited (UCOP, 2004, p.9-14). Conclusion Leasing has its own share of pros and cons. Both these factors should be taken into consideration while deciding on the type of leasing. However, more and more companies are opting for leasing to gain the benefit of reduced taxation. Leasing can be considered as a type of debt financing and can affect a firm’s future financial ability. This makes it imperative to conduct an appropriate financial analysis of the expenses and income from leased assets in order to reap the benefits of leasing. Reference ELFA. (January, 2004). Accounting & Reporting of Executory Costs. Retrieved from http://www.elfaonline.org/cvweb_elfa/Product_Downloads/ACF245E.pdf. Johnson, E. C., Mosich, N. A., & Meigs, B. W. (2003). Financial Accounting. New York: McGraw Hill. Lonza. (2005). Annual Report. Retrieved from http://www.lonza.com/group/en/company/news/reports.-ParSys-0083-DownloadFile.tmp/FR_Lonza_e.pdf. Ross, A. S., Westerfield, R. & Jaffee, J. (2004). Corporate Finance. New York: McGraw Hill. UCOP. (June, 2004). ACCOUNTING AND REPORTING FOR LEASES AND INSTALLMENT PURCHASE CONTRACTS. Retrieved from http://www.ucop.edu/ucophome/policies/acctman/l-217-11.pdf. Read More