Leasing Option Memo for Client Elizabeth P Grady ACC 541 December 5, 2011 Leslie Crews Memorandum to:Client from:Elizabeth Grady, Staff 1 subject:Leasing options memo date:december 5, 2011 ————————————————- Each year the number of leasing agreements continues to grow. There are several advantages of leasing property instead of owning. The company is protected against obsolescence and can receive 100% financing with less cost, fixed payments, and more flexibility (Schroeder, Clark, & Cathey, 2011).
The new business opportunity for the client will require 20 more trucks than XYZ Trucking Inc. currently owns. The FASB issued SFAS No. 13, “Accounting for Leases” to establish standards of financial accounting and reporting for the lessees and lessors. The three leasing options to available are operating, sales-type, and direct financing. This memo will define each option, compare operating versus capitalizing and give a recommendation for XYZ Company. Lease Definitions
A lease can be either capital or operating. It is considered to be a capitalized lease when all the benefits and risks of ownership are transferred to the lessee. To be a capitalized lease it must be noncancelable and meet one of the four following criteria in group 1. The lease must transfer ownership, include a bargain purchase option, have lease terms of at least 75% of the economic life, or present value of lease payments equal to 90% or more of the fair market value (FASB, 2011).
The two additional qualities in group 2 are reasonable assurance of the collectability on payments from the lessee and the lessor’s performance is substantially complete. If none of these terms are met the lease is considered operating. Capital Leases A sales-type and direct financing lease are capital leases. A capital lease is an agreement in which the lessor finances the acquisition of the property for the lessee; similar to installment purchase agreements (Schroeder, Clark, & Cathey, 2011).
A sales-type lease must meet at least one of the four capital lease criteria in group 1, both in group 2, and involve a manufacturer’s or dealer’s profit on the sale of the asset. The profit is generated from the fair market value exceeding the carrying value of the asset. A sales-type and direct financing lease are the same except in one respect. A direct financing lease does not involve a manufacturer or dealer and the asset’s fair market value equals the lessor’s book value. Operating Leases
A lease is classified as an operating lease when it does not meet the criteria in group 1 or group 2. An operating lease is viewed as a rental agreement between the lessor and lessee. From an accounting viewpoint, an operating lease is considered the simplest type of lease arrangement. It gives the right to use property for a determine amount of time. An operating lease is not reported as long-term debt on the balance sheet but needs to be disclosed if noncancelable terms exceed on year (Kieso, Weygandt, & Warfield, 2007).
An operating lease offers flexibility on the duration of time and rental payment to tailor the needs of the lessee. The lease duration can be a long or short period of time with possible renewal incentives. The payments can be predetermined fixed amounts or vary based on sales, interest rate or other factors. Operating vs. Capital Leases The differences between an operating and capital lease are important to know because it will help evaluate which type the company should choose.
The total charges for the lease are the same but under a capital lease the charges are higher in the beginning years and less at the end than an operating lease (Ingberman, Ronen, & Sorter, 1979). The biggest notable difference is the handling of each on the financial statements. An operating lease is similar to a rental agreement so there is no long-term liability on the balance sheet. It allows the lessee to engage in off-balance sheet financing. This provides several benefits for the company to maintain a good financial position.
When a company enters a capital lease the asset is reported on the balance sheet. This results in the debt to total equity increasing and the rate of return on total assets to decrease. The ratios can negatively affect financing opportunities, the corporate bond covenants, and management compensation incentives (Schroeder, Clark, & Cathey, 2011). In addition, the depreciation required on the asset in a capital lease will result in a deferred tax. The funds from operations on the cash flow statement will be higher by the deferred tax when a capital lease is used (Ingberman, Ronen, & Sorter, 1979).
The cash from the operations section on the cash flow must be reconciled to remove noncash items during the period (Kieso, Weygandt, & Warfield, 2007). The company will receive benefits from both types of leases; the right option for the company will depend on their needs and strategy. Recommendation The recommendation for XYZ Trucking Inc. is to sign a short-term operating lease with a renewal option. The uncertainty by XYZ Trucking on the length of this relationship where the additional 20 trucks are required is the main justification for this recommendation.
The company should not enter a long-term capital lease where a future purchase is expected for vehicles that may not be needed. A short-term operating lease with a renewal option offers the flexibility during this uncertain period and the opportunity to make a long-term decision once more information is available. At that point, the company can determine if a capital lease will be more beneficial. Conclusion The leasing environment offers many options for a company to lease instead of buy. The advantages to lease are drawing more businesses each year to this option.
A company in the position similar to XYZ Trucking can use a lease as a short-term option until they have more knowledge to make an informed long-term decision. If the company determines they need the trucks long-term they can move to a capital lease. A capital lease offers them the mechanism to acquire the trucks while still taking advantage of the benefits a lease offers. XYZ Trucking is in an excellent position to expand their business and should use the available lease options to maximize this opportunity. References FASB. (2011).
Accounting Standards Codification. Retrieved from https://asc. fasb. org/home Ingberman, M. , Ronen, J. , & Sorter, G. H. (1979, Feb). How Lease Capitalization Under FASB Statement No. 13 Will Affect Financial Ratios. Financial Analysts Journal, 35(1), p 28. Kieso, D. E. , Weygandt, J. J. , & Warfield, T. D. (2007). Intermediate accounting (12th ed. ). Hoboken, NJ: Wiley. Schroeder, R. G. , Clark, M. W. , & Cathey, J. M. (2011). Financial Accounting Theory and Analysis; Text readings and cases (10th Ed. ). Hoboken, NJ: Wiley.