Leasing Basics – The Different Types of Lease Agreements
Whether you are an individual or a business and whether your acquisition is for personal or business use there are various ways of financing that asset. Which you choose will depend on a combination of experience, preference, requirement, estimated usage, availability and financial options and restrictions.
Leasing makes available to you an asset or assets for generally (though not necessarily) a minimum period for a regular (usually fixed) rental. A lease agreement is drawn up between the owner of the asset (lessor) and the user of the asset (lessee) and is a legal contract with rights and obligations on both sides.
To Lease or not to Lease?
If you haven’t leased before then further on in this blog, we will discuss the types of lease available and how you might ascertain the right choice for you or your business! But first, let us consider the arguments for and against leasing.
- What is your experience of asset ownership? Has ownership led you to sweat assets such that their unreliability or lack of today’s functionality cost your business time and money? Is it possible to remain more start of the art by leasing assets and regularly refreshing them?
- Is the asset you need more readily available as a purchase or as a rental. It may be easier to lease an aeroplane today from a lessor rather than join the queue to purchase one from a manufacturer. You may even need a crew and maintenance to go with it – “a wet lease”.
- Is this acquisition for a short-term project or a long-term one? A car rental for example while a vehicle is in for repair is a different proposition from that of making available an automobile to an employee as part of his package. Again, this may comprise a “wet” or “dry” lease
- Some assets are essential for an operation but need not be in use all of the time. Construction companies are building all of the time, but they do not always need a tower crane and certainly do not need a tower crane fixed in one location. It might be more expedient to rent or lease such equipment when needed and where needed rather than buy, erect, use, dismantle, move, erect, use, dismantle………
- Assets (other than arguably property) tend to depreciate in value and to an extent, usefulness over time. Is ownership tying up capital? Is your business one that owns its asset or one that uses assets to supply products and services to your customers. Can that capital be better employed within the business?
- Have you spoken with your tax advisers to investigate any advantages that might be realised through leasing over purchase or hire purchase? Then there is VAT and Sales Tax.
- Is lack of available capital holding back development? Could the acquisition of an asset help your business plan be more easily met? Renting or leasing may get around this “bottleneck”. Speak with the powers that be.
- You probably already lease your telephones, mobile phones, copier equipment and other smaller ticket items. This flexibility allows regular refreshes of equipment, guaranteed uptimes and performance – why not investigate the features available with other asset types?
Lessee and Lessor – who is who?
The lessee would be the user of the asset. The lessor would be the owner though not necessarily the supplier or manufacturer of the asset. The lessor may be a subsidiary or part of the supplier or manufacturer but can equally be an independent lessor specialising in the rental of that equipment type or a financial institution or even your own bankers.
- Manufacturer or supplier connected lessors are generally in the business of assisting their parent companies in the sale of assets and the replacement of those assets at lease expiry.
- Independent lessors tend to operate as residual value takers in equipment whether vehicles, IT, medical etc. with a view to remarketing, recycling or retiring the assets at expiry. They tend to specialise in certain asset types.
- Banks and other financial institutions offer leasing to their customers as an additional avenue for borrowing. Though much like a bank loan the difference is that the loan is secured against the assets and that may result in more advantageous rates.
Lessees, as stated, tend to be the user of the asset though they, in turn, may have the ability and need to sub-lease the equipment to a sub-lessee – often the case for operations offering short-term rental of IT kit.
How you choose to lease is very much down to you. Generally, it is easier to identify the asset required, then the supplier and finally check finance options available in-house and externally prior to an acquisition. Assuming you opt for a lease then with all this in place you can then order the equipment with delivery to your premises but invoicing by the supplier to your chosen lessor who will on your acceptance of the equipment pay the invoice and acquire title and ownership to it. You will then “enjoy quiet possession and use” of the asset under the terms of the lease contract for the duration of the agreement. If you have already purchased or always need to purchase the asset, then do not despair as you may be able to still sell the assets to an Independent Lessor or Bank in what is called a Sale and Lease Back transaction. This may free up capital in owned assets or be the preferred way of your business acquiring a basket of assets and then leasing them all in one transaction for a stated period using an available facility – regular drawdowns. See our blog on “IFRS 16: Sale and Leaseback Explained”.
Lease Agreements and Contracts
Like most agreements, lease contracts are between two parties and are legally binding on both sides. They tend to comprise a number of documents, all of which become important particularly in areas of dispute. Choosing the right lessor, the appropriate type of lease and the fair and equitable terms are paramount. All lease agreements are basically the same and are there to protect the lessor, his asset and his interests. However, you will find that there is rarely time or resource within your organisation to comprehend and negotiate the terms which may lead to the acquisition of the right of use of the assets without full regard for your concerns or needs. Firms specialising in this area do exist and consulting them will save you time and money. They, like Innervision, have the experience and connections to ensure the right type of lessor offers the right type of lease over the appropriate period for a fair rental. End of lease options will be understood and documented – returns, extensions and buyouts.
LOIS – A lease accounting and lease management solution from Innervision will ensure that you manage your lease portfolio and your lessors. The type of documents you will come across are likely to be a:
- Master Agreement – document agreed between the two parties setting out the “standard” terms and conditions under which the lessor will make available the use of assets to the lessee
- Equipment Schedule – generated for each transaction under the Master Agreement, it will likely detail the length of the lease, the payment schedule, the equipment details and intended start date. Additionally, there may be variations to the Master Agreement documented here to specifically reflect the nature of the lessee or particular piece of equipment.
- Acceptance Certificate – this document will be filled in by the lessee when he is happy that the equipment is delivered, working and acceptable in line with the equipment schedule. The signing of it and will normally start the lease of the equipment.
- From a bank an all-purpose “universal” document that caters for everything from vehicle to copier but specialises in none.
- From an Independent, a specialist document usually suited to IT or Medical or Vehicle etc.
- From a manufacturer a document written with their own equipment in mind.
Engaging with a consultancy such as Innervision may not just save time but will allow you to concentrate on the selection of the asset and its pricing. The choice of the lessor and the appropriate documentation is specialist and should be left to the specialists. Even your own legal team are unlikely to be unfamiliar with leasing contracts, leasing law and associated conditions.
Lease Types – past and present
The adoption of new lease accounting standards has meant some real change in the way leases are accounted for but the variety of lease types available remains pretty much the same. The new standards are IFRS 16 (issued by the International Accounting Standards Board- IASB) and ASC 842 (from Financial Accounting Standards Board – FASB) and stipulate the treatment of leased assets and associated payment liabilities with regard to P&L and Balance Sheet entries. From now going forward with just a couple of exceptions all leases will be treated by the lessee as “finance type leases”.
On a practical note rather than an accounting one leases divide pretty much into two pots and from there we can look at options available within each pot. Each type may include an element of service – operation, maintenance or equipment warranty perhaps (a “wet” lease as opposed to a “dry” lease) but this element needs to be differentiated from the lease for accounting purposes.
- Operating Leases – here the lessor retains economic ownership of the equipment as well as title. For the rental will be accorded a right of use asset and will be committed to certain liabilities for payments. The rental you will pay will likely reflect the equipment’s value at the projected expiry date of the lease. The present value of the lease rentals will generally be less than the purchase price of the asset. Particularly associated with vehicles and aircraft, equipment and plant as well as property this type of lease reflects the short to medium term needs of a business for a particular asset. At lease end, the typical options will be –
- Return the equipment in good order (allowing for fair wear and tear).
- Extend the equipment lease for a further fixed period usually at a rental to reflect its fair market value.
- Roll the lease at the same periodic rental period by period.
- Extend the lease at predetermined rental documented in the lease schedule.
- Sometimes an asset update, refresh or replacement option is available but the terms for this need to be carefully documented and priced.
Prior to IFRS 16 and ASC 842 an operating type lease could be expensed rather than capitalised. From 2019 all leased assets must be capitalised. Exceptions that can be applied are assets rented for less than 12 months or low-value assets (<$5,000).
- Finance Leases – here the lessor purchases the equipment and as a reflection of the rentals (generally higher than those of an operating type lease) transfers economic ownership to the lessee. From the lessee’s perspective, this is almost a bank loan and has always been treated by accounts as an asset (to be depreciated) with associated contingent liabilities. It is a form of borrowing and is accounted as such. This is usually reflected in the expiry options –
- Continue to lease the equipment for a “peppercorn” rental – generally less than 1% per annum of original capital cost.
- Buy out the asset by paying an agreed figure to take title – in prior years this option was not always available, but it is now seen more and more.
- Return the equipment to the lessor but this is rarely taken up as an option as the full price even after discounting the rentals to the start date will always exceed the purchase price. Effectively you have paid for the asset over the primary term of the lease.
As well as leasing there are other ways of acquiring assets whether through Hire Purchase or outright purchase but to learn more about the options available then contact Innervision.
To find out more about the benefits and principles of leasing as well as advice and guidance on how to maximize its potential, take a look at our ‘Ultimate Guide to Leasing – The Basics’ by following the link below: