A Step by Step Guide
Businesses have difficulty raising capital - that's no secret. This difficulty (among other reasons) has caused many to look at leasing as an alternative financing arrangement for acquiring the use of assets. All types of equipment leasing-from motor vehicles to computers, from manufacturing machinery to office furniture-have become more and more attractive.
This guide describes various aspects of the lease/buy decision. It lists advantages and disadvantages of leasing and provides a format for comparing costs of the options.
Table of Contents
2. What Is a Lease?
3. Types of Leases
4. Kinds of Lessors
5. Advantages of Leasing
6. Disadvantages of Leasing
7. Accounting Treatment of Leases
8. Cost Analysis of Lease v. Loan/Purchase
9. Look Before You Lease
10. How to Manage a Business Effectively
What Is a Lease?
A lease is a long term agreement to rent equipment, land, buildings, or any other asset. In return for most-but not all-of the benefits of ownership, the user (lessee) makes periodic payments to the owner of the asset (lessor). The lease payment covers the original cost of the equipment or other asset and provides the lessor a profit.
Types of Leases
There are three major kinds of leases: the financial lease, the operating lease, and the sale and leaseback.
Financial leases are most common by far. A financial lease is usually written for a term not to exceed the economic life of the equipment. You will find that a financial lease usually provides that:
Periodic payments be made,
Ownership of the equipment reverts to the lessor at the end of the lease term,
The lease is noncancellable and the lessee has a legal obligation to continue payments to the end of the term, and
The lessee agrees to maintain the equipment.
The operating lease, or "maintenance lease," can usually be canceled under conditions spelled out in the lease agreement. Maintenance of the asset is usually the responsibility of the owner (lessor). Computer equipment is often leased under this kind of lease.
The sale and leaseback is similar to the financial lease. The owner of an asset sells it to another party and simultaneously leases it back to use it for a specified term. This arrangement lets you free the money tied up in an asset for use elsewhere. You'll find that buildings are often leased this way.
You may also hear leases described as net leases or Kross leases. Under a net lease the lessee is responsible for expenses such as those for maintenance, taxes, and insurance. The lessor pays these expenses under a gross lease. Financial leases are usually net leases.
Finally, you might run across the term full payout lease. Under a full payout lease the lessor recovers the original cost of the asset during the term of the lease.
Kinds of Lessors
As the use of leasing has increased as a method for businesses to acquire the use of equipment and other assets, the number of companies in the leasing business has increased dramatically.
Commercial banks, insurance companies, and finance companies do most of the leasing. Many of these organizations have formed subsidiaries primarily concerned with equipment leasing. These subsidiaries are usually capable of making lease arrangements for almost anything.
In addition to financial organizations, there are companies which specialize in leasing. Some are engaged in general leasing, dealing with just about any kind of equipment. Others specialize in particular equipment, such as trucks or computers, for example.
Equipment manufacturers are also occasionally in the leasing business. Of course, they usually lease only the equipment they manufacture.
Advantages of Leasing
The obvious advantage to leasing is acquiring the use of an asset without making a large initial cash outlay. Compared to a loan arrangement to purchase the same equipment, a lease usually
requires no down payment, while a loan often requires 25 percent down;
Requires no restriction on a company's financial operations, while loans often do;
Spreads payments over a longer period (which means they'll be lower) than loans permit; and
Provides protections against the risk of equipment obsolescence, since the lessee can get rid of the equipment at the end of the lease.
There may also tax benefits in leasing. Lease payments are deductible as operating expenses if the arrangement is a true lease. Ownership, however, usually has greater tax advantages through depreciation. Naturally, you need to have enough income and resulting tax liability to take advantage of those two benefits.
Leasing has the further advantage that the leasing firm has acquired considerable knowledge about the kinds of equipment it leases. Thus, it can provide expert technical advice based on experience with the leased equipment.
Finally, there is one further advantage of leasing that you probably hope won't ever be of use to you. In the event of bankruptcy, claims of the lessor to the assets of a firm are more restricted than those of general creditors.
Disadvantages of Leasing
In the first place, leasing usually costs more because you lose certain tax advantages that go with ownership of an asset. Leasing may not, however, cost more if you couldn't take advantage of those benefits because you don't have enough tax liability for them to come into play.
Obviously, you also lose the economic value of the asset at the end of the lease term, since you don't own the asset. Lessees have been known to grossly underestimate the salvage value of an asset. If they had known this value from the outset, they might have decided to buy instead of lease.
Further, you must never forget that a lease is a long-term legal obligation. Usually you can't cancel a lease agreement. So, it you were to end an operation that used leased equipment, you might find you'd still have to pay as much as if you had used the equipment for the full term of the lease.
Accounting Treatment of Leases
Historically, financial leases were "off the balance sheet” financing. That is, lease obligations often were not recorded directly on the balance sheet, but listed in footnotes, instead. Not explicitly accounting for leases frequently resulted in a failure to state operational assets and liabilities fairly.
In 1977 the Financial Accounting Standards Board (FASB), the rule-making body of the accounting profession, required that capital leases be recorded on the balance sheet as both an asset and a liability. This was in recognition of the long-term nature of a lease obligation.
Other books in this category that may interest you:
Effective Cost Reduction Strategies in a Small Business
A Step by Step Guide to Extending Credit and Collection in a Small Business
A Step by Step Guide to Financing a Small Business
A Step by Step Guide to Revenue and Sales Forecasting in a Small Business
Proven Strategies to Increase Revenue and Profits in a Small Business
A Step by Step Guide
A Step by Step Guide
A Step by Step Guide to Budgeting in a Small Business
A Step by Step Guide to Cash Flow Management in a Small Business
A Step by Step Guide to Balance Sheet and Profit and Loss Statement Analysis
Guide to Self Audit the Bookkeeping and Accounting in a Small Business
Guide to Self Audit of Financial Planning and Loan Proposals in a Small Business
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