CHAPTER 1 LEASING: HISTORY AND TRENDS. By the end of this chapter, the student will be able to:

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1 CHAPTER 1 LEASING: HISTORY AND TRENDS By the end of this chapter, the student will be able to: LEARNING OBJECTIVES 1. Describe the two basic types of leases. 2. List at least five nontax attributes of leasing. 3. Explain why leasing is so popular. Leasing has become one of the major sources of capital formation in the country in recent years. The decision of a company to lease or buy equipment is a complex one involving tax regulations, accounting principles, debt structure impact, financing choices, credit lines, and other important factors. This increasing activity in the leasing area has resulted in bank participation as a growing portion of the business. Some of the leaders in the industry include Security Pacific National Bank, Citibank, Bank of America, Chemical Bank, and Chase Manhattan Bank. Much of what they and others lease nowadays includes aircraft, autos, electronics, heavy vehicles, computers, and office, manufacturing, and construction equipment. Although leasing has become extremely popular during the last few decades, it is certainly not a novel concept in the world of business. Leasing finds its origins in antiquity. Leasing of farmland and ships occurred as far back in time as the Phoenician era. In feudal times, real estate was leased to tenants who paid who paid their rent in commodities grown on the land their masters owned. However, the leasing of personal property-autos, aircraft, office equipment, and the like-is a relatively new concept. Understanding why leasing has expanded to these new areas is essential to an understanding of leasing itself. In comprehending the underlying causes of leasing's popularity, lessees will be better prepared to negotiate and structure leases, and lessors can predict profitable new opportunities within the industry and cope with changes in the business environment. Prior to discussing the reasons why leasing is popular, the reader should become familiar with basic leasing terminology regarding such topics as lessors (owners of the property) and lease types. The following provides an overview of the major types of lessors and lease classifications. LESSORS There are basically four types of lessors: commercial bank or bank-related, captive leasing subsidiaries of equipment; manufacturers, independents, and

2 financial intermediaries such as investment bankers and insurance companies that bring parties together. Whereas independents may account for the largest membership category of equipment lessors, they generally do not have the overall financial capability of the banks, bank-related entities, and captive leasing companies to handle a large volume of lease transactions. Banks are major players in the leasing market, and captives are important to manufacturers in promoting sales. A captive leasing company often can better serve the client because it has extensive knowledge of the product and can predict the residual value of an asset with greater accuracy. This removes some of the risk to the lessee and may result in a lower lease payment. BASIC LEASE TYPES There are basically two types of leases: capital and operating. Capital leases are often for longer terms and generally provide for the transfer of ownership to the lessee at the end of the lease. Operating leases are usually for shorter periods and often contain renewable options along with maintenance or service options. Most equipment is leased by direct financing or through a single investor, whereby the lessor provides 100 percent financing for the equipment. Property covered through this type of arrangement includes computers, autos, and office machinery. Third-party investors often help lessors finance the purchase of expensive items such as oil drilling rigs, aircraft, and rail transportation equipment. This type of financial lease is referred to as leveraged leasing. WHY LEASING IS SO POPULAR Leasing has become popular in recent years because there has been a trend focusing on the ability to use property rather than on the legal ownership of property. Other reasons often mentioned include the sharing of tax benefits between lessors and lessees. However, the big incentive for leasing continues to be its nontax attributes. These include flexibility of leases, leasing as a hedge against obsolescence and inflation, servicing and maintenance contracts, convenience, cheaper costs (economies of scale), offbalance-sheet financing (when the lease does not appear on the face of the balance sheet), and a simple inability to obtain the financing to buy. A discussion of leasing attributes follows. Many businesspeople have come to realize that the use of a piece of equipment is far more important to the production of income than the possession of a piece of paper conveying title to the equipment. In fact, if equipment can be used by someone for most of its economic life without his or her having the full legal responsibilities, risks, and burdens of ownership, then why should he or she ever desire to own it? Even farmers and ranchers, who may have traditionally valued land ownership, now readily acknowledge that the use of land is more important than owning it. USE VERSUS OWNERSHIP

3 A similar change in emphasis has occurred in the accounting field. Until World War II, the accounting profession tended to judge a company's success by its balance sheet-that is, by what it owned. Net worth was the all-important yardstick (proprietary theory). As companies moved into the postwar expansionary period, they financed their growth with borrowed funds. The lenders of these funds were more interested in having their interest paid when due than in the net worth of the company (entity theory). This shift in emphasis in accounting brought the income statement into prominence. The income statement measures the result of the use of what is owned and, from the income results, interest is paid to creditors. The balance sheet, therefore, began to take a second position. For example, the last-in-first-out (LIFO) inventory method better matches inflationary rises in cost with the inflated revenue shown on the income statement, but this method acts to the detriment of the balance sheet since LIFO inventories are carried on the balance sheet at costs far below market prices. Consequently, LIFO balance sheets understate costs in order to make the income statement more accurate, thus making measuring the results of the use of assets more important than measuring the ownership of assets. Since operating leases are a form of off-balance-sheet financing, a company's return on assets is improved; such improvement occurs because net income is divided by a smaller asset base. Since a company's operating results are frequently judged by return on assets (leasing an asset without obtaining ownership avoids capitalization and inclusion in the balance sheet, thus causing return on assets to increase), the use of operating leases may be helpful. A big boost to leasing over the years had been the sharing of large tax benefits between lessors and lessees created through accelerated depreciation and investment tax write-offs. Lessees in low or negative tax positions would not be able to enjoy the full tax benefits through asset ownership. However, lessors in high tax positions would often share some of the tax benefits through competitive lease pricing. In 1981, Congress enacted the Economic Recovery Tax Act (ERTA), which significantly increased the tax benefits through the Accelerated Cost Recovery System (ACRS) by shortening the recovery period for the investment tax credit (ITC). In addition, ERTA introduced safe-harbor leasing, which liberalized the provisions of leasing by removing stringent profit-motive standards. With safe-harbor leasing, lessors and lessees could engage in a transaction motivated by a pure tax benefit transfer. Under prior legislation, this was illegal. Since 1981, every major tax bill has included provisions that remove some of the tax incentives created through leasing. The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) repealed the safe-harbor rules of ERTA and established "finance lease" rules that mandated that leases need to have a substantive economic purpose other than for tax benefit transfers. The Deficit Reduction Act (DRA) of 1984 further modified some of the tax rules by changing the ITC and reducing some of the depreciation available on property leased to tax-exempt entities. Finally, the Tax Reform Act of 1986 had an impact on equipment leasing, since the law eliminated the investment tax credit, modified the TAX CONSIDERATIONS

4 depreciation allowances, lowered corporate tax rates, and increased the corporate minimum tax. The first three concerns all reduced the tax benefits associated with equipment ownership, and the corporate minimum tax restricts the capacity of lessors to engage in tax-related transactions. While leasing in the past may have gained from the investment credit and other tax benefits, it does not depend on the the code for its survival. Much of the leasing growth in recent years has been a result of nontax attributes. While many lease and tax experts generally agree that some companies, especially nonfinancial companies that did leveraged leasing primarily for the tax advantage, have left the leasing market, they also point out that a principal purpose of leasing is for asset use, not ownership. NONTAX ATTRIBUTES FLEXIBILITY OF LEASES Flexibility is a primary factor in the recent growth of leasing. The ability of the lessor to structure the terms of a lease agreement specifically, regarding both the physical usage and financing of the property, should continue to support leasing in the years ahead. A brief list of several types of lease follows: A swap lease allows the lessee to exchange equipment in need of repair for properly working replacement equipment, thus avoiding costly maintenance delays. Conventional financiers seldom allow such exchanges because there are legal complexities involved in exchanging collateral. In an upgrade lease, automatic exchange of outmoded equipment with upgraded equipment is provided for during the lease. A master lease is a blanket lease that covers numerous articles of equipment that arrive over a period of time. In a joint-venture lease, several lessees join together to lease an expensive piece of equipment. With a variable payment lease, if equipment may remain idle during a portion of a company's fiscal year because of adverse weather conditions or other factors, the lease can be designed to omit payments during this period each year. In a trial period lease, a period of trial use of up to six months is provided for; during this time, the lessee can decide whether the asset will accomplish the required task, and, more important, whether it will generate revenue. This removes a good deal of the speculative risk from the lessee's acquisition of an asset. In addition to allowing flexible provisions, as previously described, leases seldom contain the restrictive covenants usually found in loan agreements. For example, some loan agreements prohibit future financing of equipment until the loan is paid down significantly; leasing generally allows further expansion without restriction. OBSOLESCENCE OF EQUIPMENT Another reason why use of equipment has been emphasized is that penalties are attached to the ownership of equipment, such as computers, developed by high-technology industries undergoing rapid growth. Some computers have even become obsolete between the order date and the

5 delivery date-and who wants to own an outmoded piece of equipment? Short-term, cancelable leases permit firms to avoid the pitfalls of owning obsolete equipment. If a piece of equipment becomes outdated, the lessee cancels the lease and orders updated equipment (upgrade lease). A renewable operating lease enables a lessee to transfer the obsolescence risk to the lessor who, presumably, is in a better position to resell a product and forecast the residual value of a piece of equipment. Some lessors even specialize in equipment for which the risk of technological obsolescence is great. COST AND CONVENIENCE Some lessees are attracted to leasing because of lower costs, fewer down payment requirements, and convenience. Leasing companies generally require a lower down payment than other financial institutions. For example, the typical lease requires the first and last rental payments in advance (representing 2 to 4 percent down), whereas many banks require 10 to 20 percent as a down payment. In addition, other incidental costs of acquiring the asset, such as sales tax and installation charges, can be included as part of the lease payments rather than being paid in advance along with the large down payment (as required by lenders). Frequently, the opportunity cost of tying up cash in equipment acquisitions is high enough that it almost necessitates leasing as an alternative. This is especially true for rapidly growing companies where available funds are tied up in accounts receivable and inventory. For instance, if an owner of a successful, small but growing firm wants a piece of equipment that he or she cannot afford to buy from internally generated or borrowed funds, he or she may be able to lease it immediately. LEASING AS AN INFLATION HEDGE Compared to conventional equipment financing, with its large down payments and short-term payouts, leasing may offer a hedge against inflation. The longer terms and lower down payment generally available in a lease may allow the lessee to pay future lease payments with inflated dollars. The lessor can obtain protection from inflation as well by borrowing long-term and passing this protection to the lessee in the form of equal lease payments over a long term. Generally speaking, it is better to borrow longterm in a period of inflation, assuming one's revenue sources are expected to inflate correspondingly and assuming that future inflation is not already factored into the borrowing rate or lease price. ECONOMIES OF SCALE Certain leasing companies, because of their large size, can effect savings in the form of quantity discounts received from volume purchasing. Such savings can be partially passed on to the lessee. Additional savings from economies of scale may be obtained through the service lease, in which the cost of maintaining the leased equipment is included as part of each rental payment. Autos, trucks, computers, and office copiers are examples of equipment often accompanied by a maintenance and service contract. Many lessees believe that leasing companies, due to familiarity with the equipment and their large size, may be more proficient in servicing the equipment and will therefore pass along any savings. However, it does not always follow that

6 large size and efficiency go hand in hand. Therefore, it is necessary to compare lease rates charged by competing companies. Large leasing companies usually have access to secondary markets in which returned equipment may be resold. Since operating leases tend to be short-term in nature, a great reliance is placed on the resale or salvage value. Lessors assume the risk of the resale value and are often willing to wait until the end of the lease term to realize their return objective. Thus, they are able to reduce their front-end cost to the lessee and may require a lower lease payment. OFF-BALANCE-SHEET FINANCING Leases that meet certain accounting criteria are not capitalized on the balance sheet of the lessee. Thus, the lessee can acquire the use of equipment without showing the lease as a liability on its balance sheet. As explained in the next chapter, this attribute is not as significant as it once was, owing to stricter reporting requirements and more sophisticated creditors. However, some, creditors may not consider leases as debt if they are properly structured. This may enlarge the firm's overall debt capacity. THE FUTURE The Tax Return Act of 1986 has resulted in fewer tax-oriented leases as the loss of tax benefits increases the relative cost of leasing. Nevertheless, nontax attributes associated with operating losses, such as assumption of residual risk, service contracts, and insurance provisions, will continue to make certain that the leasing industry continues to prosper.

7 INSTRUCTIONAL PROGRAMMING 1 I. Emphasis has been changed in recent years from 1. (b) to of assets. (a) cost... salvage value (b) ownership...use (c) utility... size (d) none of the above 2. Provision for replacement of obsolete equipment is in the 2. (d) lease. (a) sales type capital (b) service (c) leveraged (d) upgrade 3. Leasing offers a possible hedge against inflation because long-term 3. True (future) lease payments may be made with inflated dollars. ( ) True ( ) False 4. Because leasing companies allow lower down payments and do not 4. (c) require payment in advance of incidentals such as sales tax, a lessee can put its to more profitable use. (a) fixed assets (b) long-term debt (c) working capital (d) lease payments

8 5. Economies of sale can offer lessees cost savings through a 5. (a) lease that includes the cost of of equipment as part of each rental payment. (a) service... maintenance (b) service... replacement (c) sales type capital... replacement (d) sales type capital... maintenance 6. Leasing has many advantages despite the fact that it involves more 6. False red tape than buying does. ( ) True ( ) False 7. A lease in which several lessees lease an expensive piece of equip- 7. (c) ment is called a lease; banks usually do not accept these leases. (a) master (b) swap (c) joint-venture (d) full-payout 8. Leasing may enable a lessee to use assets without disclosing a finan- 8. True cial obligation directly on the financial statements. This may increase the amount of available debt financing to the lessees. ( ) True ( ) False 9. Which of the following are nontax attributes of leasing? 9. (e) (a) Obsolescence of equipment (b) Depreciation considerations (c) Convenience (d) Economies of scale (e) a, c, and d 10. The 1986 Tax Reform Act generally (increased/decreased) the tax 10. decreased benefits associated with ownership.