The Lessee Acquires All The Economic Benefits

Published Date: 02 Nov 2017

An asset can be a parcel of land, building or machinery which upon being leased becomes the source of revenue until the specified period is done. These assets are considered as a source of income to the business entity.

A financing vehicle is a tool, program or arrangement that allows and individual to secure finance. A rental lease can be a financing vehicle when a person establishes a lease-to-own arrangement which is between a landlord and an individual who needs a place to live.  The arrangement between the two parties is therefore a source of income to the owner.

A capital lease is a fixed-term non-cancelable lease that is similar to a loan agreement for purchase of a capital asset on installments. The lessor’s services are limited to financing the asset; the lessee pays all other costs including insurance, maintenance and taxes. The leased assets must be capitalized and shown in the lessee’s balance sheet as a fixed asset with a corresponding non-current

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liability. The lessee acquires all the economic benefits such as depreciation and risks of ownership but can claim only the interest portion of the lease payment as an expense. It is considered to have the economic characteristics of asset ownership. It would be considered a purchased asset for accounting purposes. A lease falls into this category if the following requirements are met: the life of the lease is 75% or greater than that of the asset’s life, the lease contains a purchase agreement for less than market value, the lessee gains ownership at the end of the lease period and the present value of the lease payments is greater than 90% of the asset’s market value.

An operating lease on the other hand is a cancelable short term lease written commonly by landlords and equipment manufacturers who expect to take back the leased asset after the lease term and re-lease it to other users. The lessor gives the lessee the exclusive right to possess and use the leased asset for a specific period and under specified conditions, but retains almost all risks and rewards of the ownership. The full amount of lease payments is charged as an expense on the lessee’s income statement but no associated asset or liability appears on the lessee’s balance sheet. As opposed to the capital lease this is not capitalized and is handled as a true lease or rental for accounting purposes. Operating leases have tax incentives and do not result in assets or liabilities being recorded on the lessee’s balance sheet, which can improve the lessee’s financial ratio.

The choice of lease classification has an important result on a firm’s financial

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statements.Residual value is the expected value of the sale of an asset at the end of its estimated useful life. It is the measure of the smallest value that an asset can be written to. In capital budgeting projects, residual values reflect how much you can sell the asset for after the firm has finished using it or once the asset’s generated cash flows can no longer be accurately forecasted. It is based on past models and future predictions. Every asset has a constant value, even though it depreciates in value because of time and use, an assessment of what the asset will be worth at the time it is no longer in use results in the residual value of that asset. The more often an asset can be used, the higher residual value it will be assigned therefore buildings are able to maintain a high residual value whereas machines often have a low residual value because they depreciate rapidly.

An executory cost is the expense incurred in servicing an executor contract. Insurance and maintenance costs, and property taxes incurred on a leased property are examples of such costs. Executory costs may be paid by both the lessee and the lessor depending on how the lease contract is written. However, since the risks of benefits and ownership have been transferred in a capital lease, the lessee usually incurs these costs. Many capital leases provide for the lessee provide for the lessee to pay executory costs directly. Alternatively, the lessor may pay the executory costs and add the amount to determine the periodic lease amount. Then the lessee excludes that portion of each lease payment that covers

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these executory costs from the minimum lease payments, and therefore from any present value calculations. Two recent accounting developments have profiled the importance of executory costs in determining lease classification and lessor reported revenues.

Before arriving at the decision to lease an asset for example a vehicle or building it is wise to go through some considerations and making the necessary calculations. When deciding whether to lease or sell an asset a person should try to approximate the net cost of the asset and factor in tax breaks and resale value when making the calculation. After determining which method is the most cost effective other factors can then be factored in. These are the technological aspects like the asset being obsolete of expiration before the lease does.

A new business owner may have a tendency to concentrate on the short term such as the first year of cash flow projections that may result for each alternative.

The cost of the lease can be analyzed through discounted cash flow analysis. The cash flow analysis provides an estimate of how much cash a person would need to set aside in the current time to cover the after tax costs of each facility acquisition alternative. This approach compares the cost of each alternative by considering the timing of the payments, the tax benefits, and the interest rate on a loan, the lease rate and other financial arrangements. To make the analysis certain assumptions have to be made about the economic life of the equipment, salvage value and depreciation.

These assumptions are purchase and financing terms that include closing costs, lease terms, the combined state income tax rate, the facility’s expected useful life

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to the business for depreciation purposes, the asset’s estimated value when it is sold or at the end of its useful life to the business, the cost of capital and any other costs that would incur if the facility is leased but not if purchased or vice versa. For instance, in the case of a building, the maintenance cost will need to be put into consideration.

After the assumptions the lease has to be evaluated by finding the net cash outlay during each year of the lease term. This is achieved by subtracting the tax savings from the lease payment. Each year’s net cash must then be discounted to account for the time value of money. The sum of the discounted cash flows is called the net present value of the cost of leasing.