Introduction
A lease is a lawful document, which outlines the stipulations under which a certain party agrees to rent the property from the other party. Therefore, a lease is a contractual agreement that calls the lessee (the renter) to pay the lessor (the property owner) for the use of an asset. Both the US-GAAP and International Accounting Standards (IAS) affect the regulations for leasing contracts balancing process. IAS 17.3 defines it as an agreement, which expresses the right to use plant, equipment, or property, typically for a specific period, in exchange for the cash payments. The lawful property possessor is the lessor whereas the renter receives the asset use right in return for the rental payments. Both the lessor and lessee should uphold the contract terms for a lease to remain valid. The categorization of a lease depends on whether the ownership rewards and risks transfer to the lessee (Eisfeldt, & Rampini, 2009). A lease is either a finance lease or an operating lease according to FAS 13 and IAS 17 categorization. A finance lease is a lease, which transfers all the rewards and risks incidental to an asset ownership substantially. Thus, at the finish of the lease term, the title might or might not be transferred to the lessee. On the other hand, an operating lease refers to any lease excluding a finance lease.
It is worth mentioning that a lease can be used as a financing vehicle. A financing vehicle refers to an arrangement, program, or tool, which allows a person to secure financing. Leasing is a financing method for capital equipment acquisition. Thus, leasing is essentially a medium-term facility for funding in the type of an agreement through a contract between the lessee and a lessor upon which the former is entitled to use the asset of a lessor in return for a periodic payment for a fixed period. When the leasing period ends, the lessee (the renter) has the right to purchase the equipment, and he/she is usually permitted to deduct the lease rentals cost from the taxable income (Eisfeldt, & Rampini, 2009). Businesses and individuals can procure assets through leases. Instead of investing direct capital, individuals and businesses can fulfill their asset needs such as fixture, vehicles, and equipments among others through using leases. The property owners buy the equipment that is selected by the renter, and offer it to them for a specific period. For the lease duration, the renter makes regular payments to the property owner at an agreed interest rate. When the lease period ends, the property is returned to its owner (the lessor), discarded, transferred to the business ownership, or sold to a third party. Therefore, when a lease is used as a financing vehicle, the lessee (the renter) typically retains or obtains the asset.
The FASB through FAS 13 regulates the accounting for leases. Under the accounting profession, leases are either recognized as an operating lease or capital lease. On the firms’ financial statements, an operating lease records no liability or asset, but the amount that is paid is essentially expensed as incurred. In contrast, a firm records a capital lease on its financial statements as both an asset and liability, usually at present value of rental payments (Monson, 2001). Therefore, there are two methods that the firms use in accounting for leases. Under an operating lease, the owner (the lessor) only transfers the property use right to the lessee (the renter). When the lease duration ends, the renter returns the asset to the owner. Because the renter does not assume ownership risk, the firm treats the lease expense as an operating expense in its income statement, but the lease does not affect its balance sheet (Crosby, 2003). Conversely, in a capital lease, the renter (the lessee) presumes some of the ownership risks and enjoys a number of benefits. As a result, when the lease is signed, it is documented both as an asset as well as a liability on the company's balance sheet. A firm claims depreciation on the asset every year and deducts interest expense element of lease payment every year. The capital leases thus recognize expenses earlier than comparable operating leases.
As firms have a preference of keeping leases off the books, and at times prefers deferring the expenses, a strong incentive on the part of firms exists to report all their leases as the operating leases. As a result, FASB has outlined four conditions that firms should use to treat the lease as a capital lease. One of the conditions for a lease to be treated as a capital lease is if there exists a transfer of possession to the renter at the completion of the lease term. The second condition is if there exists a choice to buy the property at a “bargain price” at lease term completion. The other condition is if the life of the lease exceeds 75 percent of asset life, and the final condition is if the lease payments present value that is discounted at a suitable rate of discount surpasses 90 percent of the asset’s fair market value (Crosby, 2003).
An operating lease and a capital lease have differences. When it is categorized as an operating lease, the firm treats its expenses as operating expense, but the operating lease fails to show up as part of the firm’s capital. When a firm categorizes its lease as a capital lease, it treats lease expenses present value as debt, and imputes interest on this amount and shows it as part of its income statement. Nonetheless, reclassifying the operating leases as the capital leases might raise the debt that the balance sheet shows substantially and in particular for firms in the sectors such as retailing and airlines that have considerable operating leases (Boatsman & Dong, 2011). The other difference between an operating lease and a capital lease is that under the operating lease, the lessee rents the property while in a capital lease; the lessee owns the property economically. Moreover, the lessee accrues the rent expense in an operating lease whereas in capital lease, and he/she records the leased property in the balance sheet and reflects the matching lease obligation.
Residual value can be described as the value of an asset that remains after it has been totally depreciated. It is the obtained value when an asset is disposed of off at the end of its meaningful life. The synonymous name for residual value in accounting is the salvage value, and the two can be used interchangeably. Residual value describes the prospect value of an asset in terms of rates of depreciation of its present value. There are a number of factors that are considered in the computation of the salvage value, which include monthly adjustments, lifecycle, seasonality, and disposal performance. The leasing company can set the remaining value of an asset by employing its historical data to accommodate its factors of adjustments.
In the computation of the residual value of an asset, the salvage value and the buying price are used together with the methods of accounting to establish the rate of depreciation of the asset in each time usually on a yearly basis. The most commonly used methods of accounting are the straight line method and declining-balance approach. Straight line method uses the following described formula to arrive at the residual value. Depreciation is obtained by deducting the scrap value from fixed asset cost and then dividing the result by the lifespan of the asset (Crosby, 2003). The declining-balance approach makes the assumption that an asset depreciates more quickly in its early stage of its meaningful lifetime. The methodology for this approach involves calculating each time of depreciation on the basis of the previous year’s net book value, projected lifetime of the asset and the double-declining balance (a factor of two).
Executory costs refer to the responsibility linked with the ownership transfer to the renter (the lessee) in a capital lease. These responsibilities come in the form of payments for repair, maintenance, taxes, insurance and any other expenses that it attaches with ownership of a capital lease. In the course of leasing capital, formal agreements are normally put on paper, in a way, that the executor costs are paid by the lease. These executory costs are usually paid out as the lessee incurs them. Nevertheless, in some lease agreements the executor costs are paid by the lessor on behalf of the lessee but it is subject to reimbursement. In such a case, the lessee meets such costs, and it is treated as a pass through expenditure by the lesser, not its portion expenses. FAS 13 require the executory costs to be excluded from the minimum lease expenses. It further states that these costs should be separately reported as a subtraction from the minimum lease expenses to obtain a ‘net' minimum leases payment. According to FAS 13, the executory costs that the renter (the lessee) pays the property owner (the lessor) are sorted out from the other rents before the capital lease’s rent income is capitalized. In addition, executory costs are made on periodic expenses and do not involve rental cost of the property. Such costs may increase, reduce or remain unchanged overtime and may be approximated by the lessee.
Before deciding on leasing a property one needs to consider a number of factors. Analysis of the costs of a lease is a vital factor to evaluate first. Analysis of the cost of a lease by looking into the payments timing, loan on interest rate, the rate of the lease, the benefits of the tax as well as other financial elements enables the lessor to make an intelligent and calculated judgments before leasing. In order to arrive at the analysis, one first needs to make particular assumptions concerning the economic lifespan of the asset, residual value and depreciation. Evaluation of a lease one must first calculate the net cash cost of the annual lease term (Boatsman & Dong, 2011). These values can be obtainable by deducting the tax savings from the paid lease. The computation of the present value is important because it ensure comparison of the actual cash streams is made over time.
The productive life of the asset is another thing to consider prior to lease an asset. The period an asset is used by a company or individual is imperative in determining whether to lease or not. In relatively short time, it is wise to opt for a lease rather than buying the asset fully. Furthermore, it advisable to lease an asset that becomes outdated faster. An asset that may be subjected to wear and tear in a faster rate will also be worthwhile to lease unlike a very durable one. Nonetheless, it is worth noting that the entire lease cost for the productive life/technological life is below the purchasing cost, it better to lease it.
The risk associated with owning the asset is another consideration that one needs to evaluate. An asset that bears a lot of risks will be wise to lease it, so as to mitigate loss associated with such risks (Monson, 2001). Tax consideration also is instrumental in determining whether to lease the property. If tax is unfavorable to the property owners, it is advisable to lease.
Furthermore, it’s vital for one to sell an asset and rent it back from the new possessor. In such a situation, the individual or company receives money from the sale of the property and leases it by paying the lease fees. The sale of the property enables the former owner to avoid risk that residual value carries with itself. The initial owner has to consider the after tax cash streams from selling the asset and the total cash invested if he/she continues to enjoy the ownership (Eisfeldt, & Rampini, 2009). Moreover, considering the selling price of the present asset is useful because it may be affected by the current fluctuations in the market. One should examine keenly the accessibility of the property in the local markets as well as the prospective impacts of the national regulations.
References
Boatsman, J., & Dong, X. (2011). Equity value implications of lease accounting. Accounting Horizons, 25(1), 1-16.
Crosby, N. (2003). Accounting for leases–the problem of rent reviews in capitalising lease liabilities. Journal of Property Investment & Finance, 21(2), 79-108.
Eisfeldt, A. L., & Rampini, A. A. (2009). Leasing, ability to repossess, and debt capacity. Review of Financial Studies, 22(4), 1621-1657.
Monson, D. W. (2001). The Conceptual Framework and Accounting for Leases. Accounting Horizons, 15(3), 275-287.
