854 SECTION 3 Financial Instruments and Liabilities Decision Makers’ Perspective—Advantages of Leasing When a young entrepreneur started a computer training center a few years ago, she had no idea how fast her business would grow. Now, while she knows she needs computers, she doesn’t know how many. Just starting out, she also has little cash with which to buy them. The mutual funds department of a large investment The U.S. Navy once leased a fleet of tankers to avoid asking Congress for appropriations. firm often needs new computers and peripherals—fast. The department manager knows he can’t afford to wait up to a year, the time it sometimes takes, to go through company channels to obtain purchase approval. An established computer software publisher recently began developing a new line of business software. The senior programmer has to be certain he’s testing the company’s products on the latest versions of computer hardware. And yet he views large expenditures on equipment subject to rapid technological change and obsolescence as risky business. Each of these individuals is faced with different predicaments and concerns. The entrepreneur is faced with uncertainty and cash flow problems, the department manager with time constraints and bureaucratic control systems, the programmer with fear of obsolescence. Though their specific concerns differ, these individuals have all met their firms’ information technology needs with the same solution: each has decided to lease the computers rather than buy them. Computers are by no means the only assets obtained through leasing arrangements. To the contrary, leasing has grown to be the most popular method of external financing of corporate assets in America. The airplane in which you last flew probably was leased, as was the gate from which it departed. Your favorite retail outlet at the local shopping mall likely leases the space it operates. Many companies actually exist for the sole purpose of acquiring assets and leasing them to others. And, leasing often is a primary method of “selling” a firm’s products. IBM and Boeing are familiar examples. In light of its popularity, you may be surprised that leasing usually is more expensive than buying. Of course, the higher apparent cost of leasing is because the lessor usually shoulders at least some of the financial and risk burdens that a purchaser normally would assume. So, why the popularity? The lease decisions described above are motivated by operational incentives. Tax and market considerations also motivate firms to lease. Sometimes leasing offers tax saving advantages over outright purchases. For instance, a company with little or no taxable income—maybe a business just getting started, or one experiencing an economic downturn—will get little benefit from depreciation deductions. But the company can benefit indirectly by leasing assets rather than buying. By allowing the lessor to retain ownership and thus benefit from depreciation deductions, the lessee often can negotiate lower lease payments. Lessees with sufficient taxable income to take advantage of the depreciation deductions, but still in lower tax brackets than lessors, also can achieve similar indirect tax benefits. The desire to obtain “off-balance-sheet financing” also is sometimes a leasing stimulus. When funds are borrowed to purchase an asset, the liability has a detrimental effect on the company’s debt to equity ratio and other quantifiable indicators of riskiness. Similarly, the purchased asset increases total assets and correspondingly lowers calculations of the rate of return on assets. Despite research that indicates otherwise, management actions continue to reflect a belief that the financial market is naive and is fooled by off-balance-sheet financing. Managers continue to avoid reporting assets and liabilities by leasing rather than buying and by constructing lease agreements in such a way that capitalizing the assets and liabilities is not required. 1 ● LO15–1 Leasing can facilitate asset acquisition. The number one method of external financing by U.S. businesses is leasing. Tax incentives often motivate leasing. Leasing sometimes is used as a means of offbalance sheet financing. 1 You will learn later in the chapter that accounting standards are designed to identify lease arrangements that, despite their outward appearance, are in reality purchases of assets. Assets acquired by these arrangements, capital leases, are required to be recorded as well as the related lease liability. Managers often structure lease terms so that capitalization requirements are avoided.
Spiceland_Inter_Accounting8e_Ch15
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