Lease financing is a medium of financing where the owner of an asset gives it on lease to someone else against fixed, usually monthly payments. The owner is known as the lessor, the person taking the lease is called the lessee and the periodical payments are known as the lease rental. While the lessee uses the asset, the lessor reserves the right to its ownership. An agreement is signed to this end and on completion of the fixed time period for which the lease has been given, the lessor may sell the asset to the lessee, end the lease or renew the agreement with the same clauses or make necessary changes.
What Are the Types of Lease Financing and How They Work?
All financial leasing agreements can be categorized into the following types:
- Capital Lease or Finance Lease or Sales Lease – Finance leasing is an agreement in which though the ownership of the asset lies with the lessor, the lessee has all operating controls and has to share the risks as well as rewards associated with the asset. Changes in valuation of the asset could lead to rewards or risks depending on the market conditions. The owner or the lessor recovers his investment and gains by interest paid by the lessee through rentals on the asset.
- Operating Lease – Operating lease is one where the risks and rewards of the asset are not transferred to the lessee. These are usually short-term leases in which the lessor rarely recovers his total investment during the primary period of the lease. Often, in such lease agreements, the lessor will offer advice regarding the service and maintenance of the asset to the lessee for smoother business. Hence, it is also referred to as service lease.
- Sale and Leaseback – In this arrangement, an asset already owned by a vendor is sold and then put on lease again by the buyer to the same vendor. The firm or vendor benefits in two ways – it receives cash by means of selling the asset and is also able to retain the economic use of it by making periodic lease rentals.
- Direct Leasing – In direct lease, the lessee acquires the permission to use an asset which it doesn’t own. This kind of agreement maybe directly between the lessee and the manufacturer of the asset or via a lease finance company. In the latter case, the finance company will arrange the purchase of the asset from the manufacturer and enter into an agreement with the lessor(manufacturer) for the lease lending.
- Leveraged Leasing – In this kind of arrangement, a lessor will purchase the asset by borrowing funds from a bank or financial institution. The asset is given as security and the rentals from the lessee are used to pay the loan installments. The lessee may directly pay the lending institution and only give the excess amount to the lessor. The lessor thus remains both the owner and the borrower. Such financing could be offered by a bank or a lease finance company.
- Straight Lease and Modified Lease – In a straight lease, the lessee firm pays rentals during the expected service period of the asset and during this period, there is no provision to make any changes to the terms and conditions of the lease. Modified lease allows changes to be made during the lease period including the option of the lessee returning the asset, terminating the lease and purchasing the asset.
- Primary and Secondary Lease – In a primary lease arrangement, the lessor recovers a major part of the cost of the asset during the initial phase of the lease while a nominal amount is left to be paid for the secondary lease. This amount is known as peppercorn rental. Another name for this kind of lease is front-ended and back-ended lease.
What is the Difference between Finance Lease and Operating Lease?
An operating lease is one in which all risks and rewards associated with the asset ownership lie with the lessor and the lessee just operates the asset. The asset is returned by the lessee at the end of the agreement term. The risks and rewards of the asset are transferred to the lessee in case of a finance or capital lease. In an operating lease, the ownership remains with the lessor for the entirety of the leasing period while in a capital lease, there is a provision for transferring ownership. In accounting records, an operating lease is treated like a rental agreement, where lease payments become business expenses and do not appear on the balance sheet. Whereas, a capital lease is treated like a loan as if the ownership comes to the lessee, it is an asset which will make it to the balance sheet.[also-recommended-box title=”” href_title=”How to Finance Equipment for Your Business” rel=”/blog/how-to-finance-equipment-for-your-business/” type=”3″] Recommended Reading for You: [/also-recommended-box]
Pros and Cons of Lease Finance
Following are the basic pros and cons of lease financing:
- It provides assured regular income to the lessor for a fixed period of time on his existing asset. Additionally, he is able to recover his entire investment on the asset via the lease rentals.
- If it is a finance lease, then the rights of ownership will lie with the lessor.
- Lessor will enjoy tax benefits as there will be depreciation of the leased asset.
- The interest rate of return on lease rental is higher than the interest to be paid for financing of the asset making leasing financing a profitable endeavor.
- There is a consistent demand of lease lenders as this kind of arrangement can be maintained even during economic crises. Leasing has a great market of growth.
- A lessee on the other hand does not have to spend a huge amount for acquiring an asset and needs to pay only small, monthly rentals.
- Lease payments are mostly considered business expenses and can thus entail tax benefits.
- Lease rentals remain fixed irrespective of inflation, thus the lessee isn’t affected.
- Since the lease rentals remain fixed, the lessor cannot increase the amount even if there is an inflation or if the value of his asset currently higher than that at the beginning of the agreement.
- Sales tax may be double in certain cases – once during the purchase of the asset and again during leasing.
- If the lessee is not cautious, there might be damage to the asset making it unusable at the end of the lease period.
- Lease agreements cannot be ended midway and thus if the lessee finds the asset to be a bad investment, he cannot stop the rentals midway.
- As the lessee is not the owner of the asset, it cannot be reflected as one’s asset in the accounting balance sheet leading to understatement.
Accounting Treatment in the USA
According to the US accounting standards, a lease which meets any of the following criteria will be considered a finance lease:
- The lessee becomes the owner of the asset at the end of the agreement term
- The lease agreement has the provision whereby the lessee may purchase the asset and he is more or less certain about doing it
- The lease term is for 75% of the asset’s remaining economic life
- The current value of the lease rentals and the remaining value to be paid by the lessee is equal to or exceeds the total value of the asset
- The asset must be of such a special nature that it ceases to have any alternative use to the lessor at the end of the agreement.
- Since a finance lease is capitalized, both assets and liabilities in the balance sheet increase. As a consequence, working capital stays the same.
The GAAP Accounting standards suggests that such a lease be considered as a purchase which is reflected as such on the lessee’s balance sheet.
Recommended Lenders for Lease Finance
- Ondeck – Ondeck is known for its prompt short term small business loans supporting small businesses. They offer SBA PPP loans, term loans and line of credit.
- Lendio – A well known name in the lease funding arena, Lendio offers a simple 15-minute online application process where documents can be uploaded if required too. They have a host of loan types to choose from such as SBA loans, business acquisition loans, short term loan, commercial mortgage and so on.
Leasing Strategies to Improve Financial Stability during the COVID-19 Pandemic
Never before have had businesses worldwide understood the importance of being prepared for a crisis as now, during the COVID-19 pandemic. Here is how leasing could help bring financial stability to the table again:
- Consider the sale and leaseback format of leasing for bringing some cash back by leasing out equipment and other assets purchased during the last 6- 12 months. This would allow firms to reserve cash, diversify sources of funding and take advantage of low rates.
- You can take advantage of the low market rates by locking the lease line of credit. You can use it to cover any long-term capital projects you have planned for the coming year.
- You should opt for a leasing company which has flexible payment options, for example provisions regarding deferred payments and so on.
As cash flow becomes scarcer in times of the pandemic, small businesses are likely to find solace in options such as lease financing to keep their small businesses running.