Lease a Financing Vehicle How Leases Accounted Essay

  • Length: 6 pages
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  • Subject: Economics
  • Type: Essay
  • Paper: #15039108

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lease a financing vehicle? How leases accounted firm's financial reports? What difference a capital lease

Leasing Alternatives

Essentially, leases are alternative means of gaining access to products or goods that could otherwise be purchased outright. There is a certain degree of irony in this definition, primarily due to the fact that there are forms of leases which are extremely similar to purchases, although they contain key distinctions that still make it more feasible for an individual or an organization to lease a product rather than to simply buy it. Varying leases have different effects upon financial reports and taxable standings for companies and for individuals, who largely decide to whether or not they want to lease or purchase something based upon certain factors including status of ownership, residual value, executory costs, and both means and methods of financing. The particulars of all of these aspects of the leasing process can be suitably elucidated primarily through the means of comparing the two most widely used leasing formats: an operating and a capital lease.

In simple terms, the most important area of distinction between a capital lease and an operating lease is in the status of ownership. Operating leases are those in which the lessor merely grants the right to use whatever object is being leased to the lessee, who will never own the product and who agrees to return it after the terms of the lease, which include a specified length of time as well as an allotted schedule of payments which are frequently monthly, quarterly, or even annually based. Capital leases, on the other hand, are those in which the lessee assumes some part of the ownership (which may come to include total ownership) of the particular product being leased (Lee). In this latter example, such a lease is widely regarded as a purchase on the part of the lessee and a sale on the part of the lessor, which has been arraigned as a process of debt financing.

The financial implications for these two type of loans and their effects in terms of assets, capital, and debt, are fairly significant and worthy of a good amount of consideration. It should be understood that leases are preferable to purchases for many companies who are looking to procure long-term assets, for the simple fact that there is a greater potential to upgrade products and take advantage of technological developments with leases in a way that is not available through a purchase in which a company is simply stuck with whatever goods it has previously purchased. Many such companies prefer to utilize operating leases not only due to the aforementioned reasons, but also for the fact that since the company is not responsible for the ownership of the item in question, that company can treat the item as an operating expense, keep it off of its balance sheet, and have significantly less financial responsibility for it had it been bought or procured with a capital lease, specifically in terms of tax liability. Operating leases are not included in a firm's capital and are largely omitted from financial records, which benefits a great number of companies that would rather keep their financial information to themselves and not have to be taxed for the access of goods -- which is exactly what happens with purchases and capital leases.

However, largely due to the fact that ownership constitutes a primary part in the terms of a capital lease, there are substantially more financial obligations that come with it. The lessee incurs both risks and boons of ownership -- the former includes 'wear and tear' and the liability of the payments of the lease itself, while the latter includes tax breaks for the subtraction of the interest paid for the lease in addition to the claiming of depreciation. In ideal terms for the lessee, depreciation may occur beyond the terms of the lease and include the duration of the useful life of the asset itself, which usually takes place when there is a transfer of ownership or a bargain purchase option. However, one of the fundamental differences between capital and operating leases is that for a capital lease, the value of the lease's expense is considered a debt. Therefore, interest is calculated on the amount of the value of the lease, and accounted for as such on an income statement, which affects purposes of taxation.

In terms of decisions in regards to whether to lease or purchase something, one of the principal factors influencing this process is what type of lease it will be -- whether capital or operational. If a company can procure a lease that will be operational, it is much more likely to lease whatever the proposed product is rather than buy it. However, if it is not possible to secure an operational lease, it may be more beneficial to an organization to purchase the product. While the proclivity to lease items on an operational basis is fairly ubiquitous amongst prudent businesses, there are four criteria for determining whether or not an specific product can be mandated as an operational or as a capital lease. These regulations were initially imposed by the Financial Accounting Standards Board, which determined that a lease is capital is it meets any of the following conditions.

If the duration of the lease is greater than 75% of the life of the asset, then the lease must be capital. Additionally, a lease that grants consumers the opportunity to purchase the product at a discounted rate upon the conclusion of the terms of the lease is a capital lease. It does not matter whether or not the lessee actually chooses to purchase the aforementioned asset; if there is an option to do so, then the lease is considered capital. Similarly, it should be noted if there actually is a transfer in the ownership of the product following the completion of the lease, it is deemed a capital lease. And lastly, if the present value of the amount of the lease payments is found to be more than 90% of the fair market value at the beginning of the leasing period, it is also a capital lease.

Still another influential factor that significantly impacts the decision of whether to lease or by an asset is related to the obligations of income tax. In the case of a capital lease, the lessor acknowledges the expenses associated with the revenue that will come from the present value of projected cash flow. Subsequently, the assets being leased will be input on the balance sheet of the lessee that registers them as a fixed asset, which grants the economic benefits of depreciation, while readily acknowledging that only the interest portion of the lease payment as an expense, since the title of the object still belongs to the lessor. That interest revenue will be indicated as paid for the duration of the lease, since it part of the asset on the balance sheet. However, the most critical component of the accounting process that factors considerably into the decision of whether to lease or to buy hinges upon the fact that the tax benefits of the leased item can only be warranted if the lease is an operating lease. Full tax benefits cannot be claimed for capital leases due to the partial ownership of the item being financed. This is another reason why most organizations tend to lease items specifically if they can be procured with an operating lease. Without those same tax benefits, companies may often decide to buy if the long-term value of the product can adhere to that of the market rate of depreciation, as well as account for and justify the cost of the item being considered.

Of prime importance in the possibility of leasing an asset is its residual value, which is the name for the monetary worth of a particular item at the time that the terms of the lease have come to a conclusion (Reed). Residual value is often times employed in the initial leasing agreement as one of the most important factors in rendering the price of a specific lease, in which there is usually room for negotiation in the initial upfront capital required to secure the lease. Additionally, the residual value of a particular item is a reasonable sum of money that an organization can expect to sell a fixed asset for upon the conclusion of its useful lifespan. As applied to a capital lease, residual value is of significantly less importance than that of an operating lease -- which may account for the bargain purchase option in many leases that is one of the determining factors in constituting them as capital leases. These leases generally constitute full payment of an item, since the amounts of the payments the lessee makes effectively account for (or amortize) the entire cost that the lessor has leased the item for. Such costs include all applicable overheads, financing costs, and profit margins, and are generally independent of an asset's residual…

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