Equipment Leasing Basics

Introduction

Most organizations face the need to acquire equipment necessary to conduct daily activities of operating as a business. They need everything including manufacturing equipment, office equipment, furniture, computers, communications systems, etc. How to pay for these items can place a severe burden on the financial health of the company. Most often companies will try to pay cash either from operating capital or through bank financing. Paying cash can potentially use up large portions of their operating budget. Bank financing can sometimes be difficult to arrange particularly if the company already has a large amount of debt.

Leasing is a viable option when acquiring new equipment. Many organizations effectively use leasing for many reasons including cash flow management, a hedge against technological obsolescence, or sometimes just because it is more convenient. This paper offers a brief overview of lease terms and summarizes the benefits of leasing.

Disclaimers

The intent of this overview is to provide the basics with respect to leasing. However, it would be prudent for any organization considering leasing as an option to conduct the following reviews:

  • Finance Department Review
  • Accounting Review
  • Tax/Legal Review

These reviews are necessary in order to justify leasing as the most attractive option using the organization’s financial information, accounting policies, and tax and legal practices.

Lease Basics – Definition and Types

Definition of a Lease

A lease is a contract in which one party conveys the use of an asset to another party for a specific period of time at a predetermined rate. That is, a lease is a transaction between a lessor and a lessee in which the lessor transfers possession and use of property for a
consideration, but retains all right, title and interest in and to the property over a specified term after which the property is returned to the lessor.

There are essentially four parties to a lease: the lessor; the lessee; the supplier; the lender. The lessor is the legal owner of the equipment who purchases the equipment (generally selected by the lessee) from the supplier (normally also selected by the lessee) and pays for the equipment.

The lessee leases the equipment from the lessor and pays periodic rents to the lessor. In some cases the lessor is also the lender, but typically, the lessor will “borrow” the funds necessary to purchase the equipment from an outside lender.

Lease Types

This overview focuses primarily on two types of leases, capital leases and operating leases. Each provides unique applications within an organization. The primary characteristics of these lease types are presented below.

Capital Lease

A capital lease is also known as a financial lease and has the characteristics of a purchase agreement. It is essentially a 100% loan. Full payout and $1.00 Buy Out are also terms associated with a capital lease. A capital lease has three basic characteristics: (1) it has a term equal to or greater than 12 months; (2) it is a “net” lease in that the lessee is responsible for the incidence of ownership; (3) a capital lease is full pay out.

With respect to term, a capital lease must have a term equal to or greater than 12 months. This is what distinguishes a lease from a rental. A rental in generally considered to be an instrument with a term less than 12 months. This distinction is from an accounting point of view. Rentals are neither shown on the balance sheet of the one renting the equipment for usage nor do they appear as a footnote to the financial statements. On the other hand, capital leases do appear on the balance sheet of the lessee and additional detailed disclosure is contained in the footnotes to the financial statements. When an asset is entered onto the balance sheet, along
with its corresponding liability with respect to the lease, the asset is said to be “capitalized.”

The second characteristic of a capital lease has to do with responsibility of ownership. That is, a capital lease is a “net” lease. A net lease means that the lessee is responsible for the incidence of ownership. In other words, the lessee is responsible for maintenance and repairs. Net leases typically contain a “hell or high water” clause that states that even if the equipment fails to function, the lessee is still responsible to make rental payments. Net means the lessor is providing only one thing – the money or financing. This is why lease leases are called finance leases.

Full payout is the third characteristic of a capital lease. Full payout means that the sum of the rentals will always be equal to the equipment cost plus the lessor’s targeted profit (or interest) in the transaction. What typically occurs is that at the end of the lease the lessee will usually purchase the equipment from the lessor for a nominal sum, normally $1.00. This type of contract will explicitly include a $1.00 purchase option. The reason for the nominal fee is that there needs to be consideration paid for legal transfer of title. There are instances where the purchase option is something other than $1.00. In these cases the purchase option is specified
as a fixed percentage of the equipment cost. This fixed amount is specified in the lease contract.

Operating Lease

An operating lease, also known as a fair market value lease, has the characteristics of a usage, or rental, agreement. An operating lease meets none of the four criteria set forth by the Financial Accounting Standards Board in Financial Accounting Statement No. 13 (FASB 13). These criteria are as follows:

  1. Title to the property is automatically transferred to the lessee by or at the end of the lease term;
  2. The lease contains a bargain purchase option;
  3. The lease term is equal to or greater than 75% of the estimated economic life of the leased property;
  4. The present value of the minimum lease payments at the beginning of the lease term is equal or greater than 90% of the fair market value of the property. The discount rate to determine present value shall be the lessee’s incremental borrowing rate.

If any one of the FASB 13 criteria is true, then by definition the lease is a capital lease. The first two items have to do with title transfer. With an operating lease, the title remains with the lessor at the end of the lease term. Hence, there is no automatic transfer of title. In the case of a capital lease, a $1.00 buyout is definitely considered to be a “bargain purchase option.” For an operating lease, the lessee and lessor can determine a “fair market value” for the equipment and agree on this amount as a mutually acceptable transfer price. The fair market value at the end of term in not considered a bargain purchase price. Some leases contain a fixed purchase
option, or not to exceed purchase option. As long as these are not considered to be a bargain, then the lease can still qualify as an operating lease.

The third and fourth criteria are a bit more complicated in determining if a lease qualifies as an operating lease. With respect to economic life, from an accounting point of view this is defined as the life of the asset in the hands of multiple users given normal repairs, upkeep and maintenance. For technology equipment, it is best to obtain an opinion from an independent auditor on economic life.

Finally, for the fourth criteria, the easiest way to determine the present value of the minimum lease payments at the beginning of the lease term is to use the lessee’s incremental borrowing rate. Think of this as the rate that the lessee would pay on a secured loan with an equal term to the lease being considered.

Similar to a capital lease, an operating lease has a term equal to or greater than 12 months. If a lease can be categorized as an operating lease, then from an accounting point of view any and all lease payments are fully tax deductible as an operating expense. Additionally, an operating lease qualifies for off-balance sheet financing. That is, since the lessee can fully deduct the lease payments as an operating expense, then the lessee does not have to list the equipment as an asset nor do they have to list a corresponding liability for the lease. The footnotes to the financial statements will identify all operating leases.

Most operating leases are “net” leases. Similar to a capital lease, the lessee is responsible for maintenance, repairs, insurance, etc. That is, the lessee must keep the equipment in good working order. However, on occasion, operating leases are written as “full service” leases where the lessor is responsible for maintenance, repairs, insurance, etc.

Additionally, at the end of term for an operating lease the lessee has several options with respect to disposition of the equipment. The lessee can: (1) return the equipment to the lessor; (2) purchase the equipment at fair market value; (3) continue to lease the equipment. Many times lessees will purchase the equipment at a mutually agreed fair market value. One option available to lessees, particularly for technology equipment, is the option to upgrade the equipment. Normally the lessor will provide a new lease for an upgrade that is co-terminus with the original lease.