Introduction to Corporate Finance

PART 4: CAPITAL STRUCTURE AND PAYOUT POLICY

Operating Leases

An operating lease is a contractual arrangement whereby the lessee agrees to make periodic payments to

the lessor, often for five years or less, to obtain an asset’s services, but does not transfer all the risks and

rewards associated with ownership of the asset. The lessee has the option to cancel the lease by paying

a cancellation fee. Assets that are leased under operating leases have useful lives that are longer than

the lease’s term, although (as with most assets) the economic usefulness of the assets declines over

time. Computer systems are prime examples of assets whose relative efficiency diminishes with new

technological developments. The operating lease is a common arrangement for obtaining such systems,

as well as for other relatively short-lived assets, such as copiers or cars. When an operating lease expires,

the lessee returns the asset to the lessor, who may lease it again or sell it. In some instances, the lease

contract will give the lessee the option to purchase the asset when the contract ends. In operating leases,

the underlying asset usually has significant market value when the lease ends, and the lessor’s original

cost generally exceeds the total value of the initial lessee’s payments.

Finance Leases

A finance lease is a lease that transfers substantially all the risks and rewards incidental to ownership of

an asset. Title may or may not eventually be transferred.^4 A finance lease is generally for a longer term than

an operating lease. A non-cancellable lease is a lease that is cancellable only:

a upon the occurrence of some remote contingency

b with the permission of the lessor

c if the lessee enters into a new lease for the same or an equivalent asset with the same lessor; or

d upon payment by the lessee of such an additional amount that, at inception of the lease, continuation

of the lease is reasonably certain.

Finance leases are non-cancellable, and therefore oblige the lessee to make payments over a pre-defined

period, or lease term. The lease term is the non-cancellable period for which the lessee has contracted to

lease the asset, together with any further terms for which the lessee has the option to continue to lease

the asset, with or without further payment, when at the inception of the lease it is reasonably certain that

the lessee will exercise the option.

Even if the lessee no longer needs the asset, payments must continue until the lease expires.

Finance leases are commonly used for leasing land, buildings and large pieces of equipment. The

non-cancellable feature of the finance lease makes it quite similar to certain types of long-term

debt, and therefore finance leases are often shown as long-term debt on the lessee’s balance sheet.

As is the case with debt, failure to make the contractual lease payments can result in bankruptcy

for the lessee.

Another distinguishing characteristic of the finance lease is that the total payments over the lease

period are greater than the lessor’s initial cost. In other words, the lessor earns a return by receiving more

than the asset’s purchase price.

Finance leases result in long-term financial commitments by the company.

4 The definition of a finance lease, non-cancellable lease and lease term are taken from Australian Accounting Standard AASB117. Sources:

http://www.aasb.gov.au/admin/file/content102/c3/AASB117_07-04_ERDRjun10_07-09.pdf (accessed 4 January 2013); and http://www.

charteredaccountants.com.au/Industry-Topics/Reporting/Australian-accounting-standards/Analysis-of-AASB-standards/AASB-117--Leases

(accessed 2 October 2015).

operating lease
A contractual arrangement
whereby the lessee agrees
to make periodic payments
to the lessor, often for five
years or less, to obtain an
asset’s services, but does not
carry the risks and rewards
of ownership. The lessee
generally receives an option
to cancel, and the asset has
a useful life longer than the
lease term

finance lease
A non-cancellable contractual
arrangement, whereby
the lessee agrees to make
periodic payments to the
lessor, typically for more than
five years, to obtain an asset’s
services