Leases with Purchase Options and Double Moral Hazard

12 Pages Posted: 7 Dec 2006

See all articles by Michael Firth

Michael Firth

Lingnan University - Department of Finance and Insurance

Derek K.Y. Chau

University of Toronto

Bin Srinidhi

University of Texas at Arlington - Department of Accounting; City University of Hong Kong (CityUHK) - Department of Accountancy

Abstract

The purpose of this paper is to explain why leases have a purchase option and how the exercise price of this option is determined. We follow Demski and Sappington's (1991) approach by using a double moral hazard setting. One limitation of their model is that the agent has unlimited liability. The agent has to have enough wealth and the obligation to buy the firm when the principal decides to exercise the put option. In our paper, this problem is resolved by using a call option, which is a feature of many lease contracts. We show that leases with a purchase option can completely resolve the double moral hazard problem even if all the variables in the model are unverifiable. It is the threat of being the residual claimant that induces the lessor to provide an efficient level of effort. On the other hand, it is the opportunity of being the residual claimant that induces the lessee to maintain the asset efficiently. Finally, the model predicts that certain leased assets are not properly accounted for under the current accounting standards for leasing.

Suggested Citation

Firth, Michael and Chau, Derek K.Y. and Srinidhi, Bin, Leases with Purchase Options and Double Moral Hazard. Journal of Business Finance & Accounting, Vol. 33, No. 9-10, pp. 1390-1401, November/December 2006, Available at SSRN: https://ssrn.com/abstract=950046 or http://dx.doi.org/10.1111/j.1468-5957.2006.00606.x

Michael Firth (Contact Author)

Lingnan University - Department of Finance and Insurance ( email )

Castle Peak Road
Tuen Mun, New Territories
Hong Kong
China
+852 2616 8160 (Phone)
+852 2466 4751 (Fax)

Derek K.Y. Chau

University of Toronto

1265 Military Trail
Scarborough, Ontario M1C 1A4
Canada

Bin Srinidhi

University of Texas at Arlington - Department of Accounting ( email )

Arlington, TX 76013
United States

City University of Hong Kong (CityUHK) - Department of Accountancy ( email )

83 Tat Chee Avenue
Kowloon
Hong Kong
China

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