A:

Bond covenants can limit the amount of leases a company can have because leasing contracts are a form of debt. Taking on more debt is a form of risk in the eyes of the bondholders, and therefore bond covenants typically restrict the amount of debt a company can take on. This restriction can sometimes come in the form of a maximum debt-to-equity ratio that the company is not allowed to surpass. If the company's debt-to-equity ratio exceeds the agreed-upon level this could constitute a breach of the contract and the bondholder has the right to seek legal remedy.

Occasionally, companies may try to hide leases off their balance sheet by claiming them as operating leases instead of capital leases, which allows them to circumvent bond ratio covenants. The lease would be treated as a capital lease if one of the following criteria is met: there is a transfer of ownership; there is a bargain purchase option in the lease; the lease life is more than 75% of the economic life of the asset; or the present value of the lease payments are more than 90% of its cost. To avoid treating the lease as a capital lease, the company may structure the lease so that it does not technically qualify as a capital lease by adjusting the lease life, lease payments or other aspects of the lease. Of course, bondholders are aware of this and often have covenants that will take into account off-balance sheet leases.

Learn more about off balance sheet debt in our article: Uncovering Hidden Debt.

This FAQ was answered by Joe Nguyen.

RELATED FAQS
  1. How have low interest rates affected lease rates in the automotive sector?

    Find out how and why lower interest rates for leasing new automobiles have helped spur more consumers to lease cars instead ... Read Answer >>
  2. At the beginning of the year, HIJ Corp. began to lease new equipment ...

    The correct answer is: b) Total Lease Payment = Interest expense + Principal repayment Step 1: Interest expense = 8.5% of ... Read Answer >>
  3. At the beginning of the year, OPQ Corp. began to lease a building using the capitalized ...

    The correct answer is: c) Step 1: Calculate the Present Value of the lease: PMT = $12,000; N = 7; I = 7.5%* Read Answer >>
  4. What kinds of real estate transactions use triple net (NNN) leases?

    Learn how a net-net-net or triple net lease works and why it is popular in commercial real estate transactions. It is also ... Read Answer >>
  5. I have a small business, and I'm considering setting up an SEP IRA. What are leased ...

    Generally, a leased employee is the employee of an outside organization from which you lease the employee's services. For ... Read Answer >>
Related Articles
  1. Managing Wealth

    What is a Capital Lease?

    A lease considered to have the economic characteristics of asset ownership.
  2. Investing

    Uncovering Hidden Debt

    Understand how financing through operating leases, synthetic leases, and securitizations affects companies' image of performance.
  3. Personal Finance

    When Is Buying A Car Better Than Leasing?

    People who lease a car are often more concerned with the short-term picture.
  4. Managing Wealth

    When Is Leasing A Car Your Best Bet?

    Leasing a car isn't right for everyone. But it's attractive for those who want low initial payments and the ability to get a new vehicle every few years.
  5. Retirement

    Retirees: Should You Buy or Lease Your Car?

    To buy or lease – that is the question. For retirees, access to safer cars, comprehensive warranties and tax deductions may drive up leasing's appeal.
  6. Managing Wealth

    Why You Should Buy A Car Instead Of Leasing

    While leasing has certain advantages, buying a car tends to save you money in the long run and offers greater flexibility.
  7. Investing

    New Wheels: Lease Or Buy?

    These two major ways to obtain a car have very different advantages and drawbacks. Find out which is best for you.
  8. Personal Finance

    Auto Leasing Hits Record High in Q4

    Auto Leasing is continuously growing in popularity as a preferred choice of financing.
  9. Managing Wealth

    4 Ways to Get the Best Deal on a Car Lease

    Car buyers typically negotiate when purchasing a vehicle, but many don't negotiate when leasing a car. There are several ways to save if you ask.
  10. Managing Wealth

    Your Lease Is Up: When Should You Buy The Car?

    In general, the fact that you know the car is to your benefit. Before deciding, compare the buyback price to what the car would go for on the open market.
RELATED TERMS
  1. Operating Lease

    A contract that allows for the use of an asset, but does not ...
  2. Leasehold

    An accounting term used to classify an asset on a company's balance ...
  3. Lease Utilization

    A financial ratio that measures how much a company uses leasing ...
  4. Closed-End Lease

    A rental agreement that puts no obligation on the lessee (the ...
  5. Bargain Renewal Option

    A clause in a lease agreement that gives the lessee the option ...
  6. Bargain Purchase Option

    An option in a lease agreement that allows the lessee to purchase ...
Hot Definitions
  1. Straddle

    An options strategy in which the investor holds a position in both a call and put with the same strike price and expiration ...
  2. Trickle-Down Theory

    An economic idea which states that decreasing marginal and capital gains tax rates - especially for corporations, investors ...
  3. North American Free Trade Agreement - NAFTA

    A regulation implemented on Jan. 1, 1994, that eventually eliminated tariffs to encourage economic activity between the United ...
  4. Agency Theory

    A supposition that explains the relationship between principals and agents in business. Agency theory is concerned with resolving ...
  5. Treasury Bill - T-Bill

    A short-term debt obligation backed by the U.S. government with a maturity of less than one year. T-bills are sold in denominations ...
  6. Index

    A statistical measure of change in an economy or a securities market. In the case of financial markets, an index is a hypothetical ...
Trading Center