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 thecountry in recent years. The decision of a company to lease or buy equip-ment is a complex one involving tax regulations, accounting principles,debt structure impact, financing choices, credit lines, and other importantfactors. This increasing activity in the leasing area has resulted in bankparticipation as a growing portion of the business. Some of the leaders inthe industry include Security Pacific National Bank, Citibank, Bank ofAmerica, Chemical Bank, and Chase Manhattan Bank. Much of what theyand others lease nowadays includes aircraft, autos, electronics, heavy vehi-cles, 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 ori-gins in antiquity. Leasing of farmland and ships occurred as far back in time asthe Phoenician era. In feudal times, real estate was leased to tenants who paidwho paid their rent in commodities grown on the land their masters owned.

However, the leasing of personal property-autos, aircraft, office equip-ment, and the like-is a relatively new concept. Understanding why leas-ing has expanded to these new areas is essential to an understanding ofleasing itself. In comprehending the underlying causes of leasing's popular-ity, lessees will be better prepared to negotiate and structure leases, andlessors can predict profitable new opportunities within the industry andcope with changes in the business environment.

Prior to discussing the reasons why leasing is popular, the reader shouldbecome familiar with basic leasing terminology regarding such topics aslessors (owners of the property) and lease types. The following provides anoverview 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

financial intermediaries such as investment bankers and insurance compa-nies that bring parties together. Whereas independents may account forthe largest membership category of equipment lessors, they generally donot have the overall financial capability of the banks, bank-related enti-ties, and captive leasing companies to handle a large volume of leasetransactions. Banks are major players in the leasing market, and captivesare important to manufacturers in promoting sales. A captive leasing com-pany often can better serve the client because it has extensive knowledgeof the product and can predict the residual value of an asset with greateraccuracy. This removes some of the risk to the lessee and may result in alower lease payment.

BASIC LEASE TYPES

There are basically two types of leases: capital and operating. Capital leasesare often for longer terms and generally provide for the transfer of owner-ship to the lessee at the end of the lease. Operating leases are usually forshorter periods and often contain renewable options along with mainte-nance or service options.

Most equipment is leased by direct financing or through a single inves-tor, 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 lessorsfinance the purchase of expensive items such as oil drilling rigs, aircraft,and rail transportation equipment. This type of financial lease is referredto as leveraged leasing.

WHY LEASING IS SO POPULAR

Leasing has become popular in recent years because there has been a trendfocusing on the ability to use property rather than on the legal ownershipof property. Other reasons often mentioned include the sharing of taxbenefits between lessors and lessees. However, the big incentive for leasingcontinues to be its nontax attributes. These include flexibility of leases,leasing as a hedge against obsolescence and inflation, servicing and main-

tenance contracts, convenience, cheaper costs (economies of scale), off-balance-sheet financing (when the lease does not appear on the face of thebalance sheet), and a simple inability to obtain the financing to buy. Adiscussion of leasing attributes follows.

Many businesspeople have come to realize that the use of a piece of equip-

USE VERSUS OWNERSHIP

ment is far more important to the production of income than the posses-sion 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 withouthis or her having the full legal responsibilities, risks, and burdens of own-ership, then why should he or she ever desire to own it? Even farmers andranchers, who may have traditionally valued land ownership, now readilyacknowledge that the use of land is more important than owning it.

A similar change in emphasis has occurred in the accounting field. UntilWorld War II, the accounting profession tended to judge a company's suc-cess by its balance sheet-that is, by what it owned. Net worth was theall-important yardstick (proprietary theory). As companies moved into thepostwar expansionary period, they financed their growth with borrowedfunds. The lenders of these funds were more interested in having theirinterest paid when due than in the net worth of the company (entity the-ory). This shift in emphasis in accounting brought the income statementinto prominence. The income statement measures the result of the use ofwhat 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 inflationaryrises in cost with the inflated revenue shown on the income statement, butthis method acts to the detriment of the balance sheet since LIFO invento-ries are carried on the balance sheet at costs far below market prices. Con-sequently, LIFO balance sheets understate costs in order to make theincome statement more accurate, thus making measuring the results of theuse of assets more important than measuring the ownership of assets.

Since operating leases are a form of off-balance-sheet financing, a com-pany's return on assets is improved; such improvement occurs because netincome is divided by a smaller asset base. Since a company's operating resultsare frequently judged by return on assets (leasing an asset without obtainingownership avoids capitalization and inclusion in the balance sheet, thus caus-ing 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

TAX CONSIDERATIONS

benefits between lessors and lessees created through accelerated deprecia-tion and investment tax write-offs. Lessees in low or negative tax positionswould not be able to enjoy the full tax benefits through asset ownership.However, lessors in high tax positions would often share some of the taxbenefits through competitive lease pricing.

In 1981, Congress enacted the Economic Recovery Tax Act (ERTA),which significantly increased the tax benefits through the AcceleratedCost Recovery System (ACRS) by shortening the recovery period for theinvestment tax credit (ITC). In addition, ERTA introduced safe-harborleasing, which liberalized the provisions of leasing by removing stringentprofit-motive standards. With safe-harbor leasing, lessors and lessees couldengage in a transaction motivated by a pure tax benefit transfer. Underprior legislation, this was illegal.

Since 1981, every major tax bill has included provisions that removesome of the tax incentives created through leasing. The Tax Equity andFiscal Responsibility Act of 1982 (TEFRA) repealed the safe-harbor rulesof ERTA and established "finance lease" rules that mandated that leases needto have a substantive economic purpose other than for tax benefit transfers.

The Deficit Reduction Act (DRA) of 1984 further modified some of thetax rules by changing the ITC and reducing some of the depreciationavailable on property leased to tax-exempt entities.

Finally, the Tax Reform Act of 1986 had an impact on equipment leas-ing, since the law eliminated the investment tax credit, modified the

depreciation allowances, lowered corporate tax rates, and increased thecorporate minimum tax. The first three concerns all reduced the tax ben-efits associated with equipment ownership, and the corporate minimumtax restricts the capacity of lessors to engage in tax-related transactions.

While leasing in the past may have gained from the investment credit and

NONTAX ATTRIBUTES

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 nontaxattributes. While many lease and tax experts generally agree that somecompanies, especially nonfinancial companies that did leveraged leasingprimarily for the tax advantage, have left the leasing market, they alsopoint out that a principal purpose of leasing is for asset use, not ownership.

FLEXIBILITY OF LEASES

Flexibility is a primary factor in the recent growth of leasing. The ability ofthe lessor to structure the terms of a lease agreement specifically, regardingboth the physical usage and financing of the property, should continue tosupport 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 repairfor properly working replacement equipment, thus avoiding costly main-tenance delays. Conventional financiers seldom allow such exchangesbecause there are legal complexities involved in exchanging collateral.In an upgrade lease, automatic exchange of outmoded equipment withupgraded equipment is provided for during the lease.A master lease is a blanket lease that covers numerous articles of equip-ment that arrive over a period of time.In a joint-venture lease, several lessees join together to lease an expen-sive piece of equipment.With a variable payment lease, if equipment may remain idle during aportion of a company's fiscal year because of adverse weather condi-tions or other factors, the lease can be designed to omit payments dur-ing this period each year.In a trial period lease, a period of trial use of up to six months is pro-vided for; during this time, the lessee can decide whether the asset willaccomplish the required task, and, more important, whether it willgenerate revenue. This removes a good deal of the speculative riskfrom the lessee's acquisition of an asset.

In addition to allowing flexible provisions, as previously described, leasesseldom contain the restrictive covenants usually found in loan agreements.For example, some loan agreements prohibit future financing of equipmentuntil the loan is paid down significantly; leasing generally allows furtherexpansion without restriction.

OBSOLESCENCE OF EQUIPMENT

Another reason why use of equipment has been emphasized is that penal-ties are attached to the ownership of equipment, such as computers, devel-oped by high-technology industries undergoing rapid growth. Somecomputers have even become obsolete between the order date and the

delivery date-and who wants to own an outmoded piece of equipment?Short-term, cancelable leases permit firms to avoid the pitfalls of owningobsolete equipment. If a piece of equipment becomes outdated, the lesseecancels the lease and orders updated equipment (upgrade lease). A renew-able operating lease enables a lessee to transfer the obsolescence risk to thelessor who, presumably, is in a better position to resell a product and fore-cast the residual value of a piece of equipment. Some lessors even special-ize 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 downpayment requirements, and convenience. Leasing companies generallyrequire a lower down payment than other financial institutions. For exam-ple, the typical lease requires the first and last rental payments in advance(representing 2 to 4 percent down), whereas many banks require 10 to 20percent as a down payment. In addition, other incidental costs of acquir-ing the asset, such as sales tax and installation charges, can be included aspart of the lease payments rather than being paid in advance along withthe large down payment (as required by lenders). Frequently, the opportu-nity cost of tying up cash in equipment acquisitions is high enough that italmost necessitates leasing as an alternative. This is especially true for rap-idly growing companies where available funds are tied up in accountsreceivable and inventory. For instance, if an owner of a successful, smallbut growing firm wants a piece of equipment that he or she cannot affordto buy from internally generated or borrowed funds, he or she may be ableto lease it immediately.

LEASING AS AN INFLATION HEDGE

Compared to conventional equipment financing, with its large down pay-ments and short-term payouts, leasing may offer a hedge against inflation.The longer terms and lower down payment generally available in a leasemay allow the lessee to pay future lease payments with inflated dollars. Thelessor can obtain protection from inflation as well by borrowing long-termand passing this protection to the lessee in the form of equal lease pay-ments over a long term. Generally speaking, it is better to borrow long-term in a period of inflation, assuming one's revenue sources are expectedto inflate correspondingly and assuming that future inflation is not alreadyfactored into the borrowing rate or lease price.

ECONOMIES OF SCALE

Certain leasing companies, because of their large size, can effect savings in theform of quantity discounts received from volume purchasing. Such savingscan be partially passed on to the lessee. Additional savings from economiesof scale may be obtained through the service lease, in which the cost ofmaintaining the leased equipment is included as part of each rental payment.

Autos, trucks, computers, and office copiers are examples of equipmentoften accompanied by a maintenance and service contract. Many lesseesbelieve that leasing companies, due to familiarity with the equipment andtheir large size, may be more proficient in servicing the equipment and willtherefore pass along any savings. However, it does not always follow that

large size and efficiency go hand in hand. Therefore, it is necessary tocompare lease rates charged by competing companies.

Large leasing companies usually have access to secondary markets inwhich returned equipment may be resold. Since operating leases tend to beshort-term in nature, a great reliance is placed on the resale or salvagevalue. Lessors assume the risk of the resale value and are often willing towait 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 requirea lower lease payment.

OFF-BALANCE-SHEET FINANCING

Leases that meet certain accounting criteria are not capitalized on the bal-ance sheet of the lessee. Thus, the lessee can acquire the use of equipmentwithout showing the lease as a liability on its balance sheet. As explainedin the next chapter, this attribute is not as significant as it once was, owingto stricter reporting requirements and more sophisticated creditors. How-ever, some, creditors may not consider leases as debt if they are properlystructured. This may enlarge the firm's overall debt capacity.

THE FUTURE

The Tax Return Act of 1986 has resulted in fewer tax-oriented leases asthe loss of tax benefits increases the relative cost of leasing. Nevertheless,nontax attributes associated with operating losses, such as assumption ofresidual risk, service contracts, and insurance provisions, will continue tomake certain that the leasing industry continues to prosper.

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 lesseecan put its

to more profitable use.(a) fixed assets(b) long-term debt(c) working capital(d) lease payments

5.

Economies of sale can offer lessees cost savings through a

5. (a)

lease that includes the cost of

of equipment as part ofeach 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 theseleases.(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 increasethe 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.