Answers and Solutions:
19 - 1
ANSWERS TO BEGINNING-OF-CHAPTER QUESTIONS
An operating lease
is one that typically requires the lessor to service the equipment, that
has a lease term that is much shorter than the life of the equipment, and that can be
cancelled by the lessee.
A capital or financial lease
has a lease term that is closer to the
expected life of the asset, that requires the lessee to provide maintenance service, and that
cannot be cancelled without a substantial penalty.
A sale and lease back
is generally set
up like a financial lease, except the leased property was formerly owned by the lessee,
who sells it to the lessor and simultaneously leases it back.
These terms are not hard and
fast, and actual leases can have some of the characteristics of operating leases and some
of financial leases.
Rules exist that, when applied, force companies to characterize leases
one way or the other.
Before 1973, when FASB 13 was passed, firms could lease on a long-term, non-
cancelable basis, and thus create a long-term liability, yet not show either the leased asset
or the liability on its balance sheet.
After FASB 13, most financial or capital leases had
to be shown on the balance sheet, with the leased asset appearing as an asset and the PV
of the future lease payments appearing as a liability.
This is called “capitalizing the
lease,” and its purpose was to cause balance sheets to better reflect companies’ actual
A lease must be capitalized if any one of the following conditions
The lease terms effectively transfer ownership of the property from the lessor to the
The lessee can purchase the property for less than its fair market value when the lease
The lease period is 75% or more of the expected life of the asset. This limits the life
of the lease.
The PV of the lease payments is 90% or more of the initial value of the asset. This
can also limit the life of the lease, and also the structure of the lease payments.
A synthetic lease involves the creation of a special purpose entity (SPE) that (1) gets a
loan, often for something like 97% of the cost of the asset which is to be leased plus
equity from some source equal to 3% of the cost, (2) then uses those funds to purchase an
asset required by the SPE’s sponsoring corporation, and (3) then the SPE leases the asset
to the corporation for a term of 3 to 5 years.
The asset is typically real property, and it
generally has a life of 20 years or more.
The sponsoring corporation basically guarantees the SPE’s loan, for when the lease
expires the sponsor must either (1) arrange for the loan to be renewed at an interest rate