A lease is a contractual agreement, under which the original owner of property permits someone else to use it.
The original owner is the lessor and the user of the property is the lessee.
Two Categories of Lease
There are many kinds of leases and subtleties to lease contracts, but the major distinction to be aware of is the difference between operating leases and capital leases. In brief,
- Operating Leases work similarly to a rental contract. When the lease contract ends, the leassee surrenders the leased property to the lessor.
- Capital Leases are so-named because property ownership transfers to the lessee. A capital lease is very similar to a financed purchase. When the lease contract is completed, the leased property remains with the lessee.
Is Leasing a Cost Effective Solution?
On first investigation, the option to lease property may not seem like the most cost-effective way to acquire property usage. Operating leases are often more expensive then rental contracts for the same property. And, the total cost of acquiring property with a capital lease may exceed the total cost of financing an outright purchase of the same property with a bank loan. Many people ask, therefore, "Why Lease?" Or, "Are there advantages to leasing, compared to purchasing?"
Why Lease? Reasons for Leasing
First Reason: Acquire More Expensive Property
A first answer to such questions is simply that leasing sometimes enables the lessee to use property that is more expensive than the lessee could afford to purchase at present. This is the case when the contract does not require a prohibitively large "up front" payment . Individuals sometimes lease automobiles for this reason: They can drive a "better class" of vehicle than they could otherwise afford.
Second Reason: Better Cash Flow NPV
A second answer is that leasing lets the lessee use expensive assets without a large initial cash expenditure. Total leasing costs may ultimately exceed total purchase costs but, in any case, leasing works to spread cash outflows more evenly across contract life.
The long-term cash outflow profile from a purchase decision can be heavily "front loaded," while the cash outflow profile from leasing decisions tends to be level or even "back loaded." As a result, discounted cash flow (DCF) analysis lowers the Net Present Value (NPV) of leasing cost cash flows more than it impacts the NPV of purchase cost cash flows.
Other Reasons for Leasing
Beyond this, however, the potential lessee may consider other advantages to leasing that stem from certain contract-specific provisions. For instance,
- The leasing contract may make it easy for the lessee to upgrade, or exchange the leased property during the life of the lease. This is typically the case for leased computer systems and vehicles.
- An operating lease enables owners to keep some assets "off the books," that is, reduce the Balance sheet asset base. As a result, asset performance metrics such as Return on Assets (ROA) and Total Asset Turnover improve.
- Other lease provisions may in fact lower some operating expenses for the lessee.
Building space leases, for instance, itemize expense lessor and lessee expense responsibilities in detail. When leasing commercial office space, lessors usually pay for normal building maintenance, for such things as roof repairs, installing fire alarms, and building insurance. At the same time, lessees usually pay for cleaning services and utilities such as heating and electricity. In many cases, however, each such responsibility is negotiable before the signing the lease.
For more on the advantages and disadvantages to leasing, see the section below The Lease vs. Buy Decision.
Explaining Lease Concepts in Context
Discussions below further explain important leasing concepts, and describe leasing practice in context with leasing-related terms including:
- What is a lease?
- Lease payments: Kinds of payments and payment timing.
- Operating leases vs. capital leases: What are the differences?
- What Makes it a "Capital" Lease? Rules for classifying leases.
- Making the Lease vs. Buy Decision.
Lease contracts will spell out completely the amounts and timing of payments the lessee must pay. The potential lessee should look for several kinds of payments that may be written into the contract:.
Periodic Lease payments
For most lease offerings, the most visible—prominently publicized—payment is the scheduled periodic payment the lessee must pay. In business, moreover, most leases specify a monthly payment plan. The term leveled payments refers to a leasing arrangement in which lessee payments to the lessor are made at the same time interval and all payments are of equal size.
An alternatives to leveled payments would be specified in the leasing contract. The most commonly used non-leveled payment schemes include:
- Scheduled annual increases in payments (this is especially common with real estate properties).
- A larger initial "up-front" payment, followed by leveled or decreasing payments.
- Declared lease holidays, that is, specified periods for which no lease payment is due.
Note that lease contracts sometimes require that one or several periodic payments be paid "up front," before the lease contract life begins.
Lease Initiation Fee
The lease initiation fee is a an up-front payment, similar to a deposit, except that lease initiation fees are always non-refundable. The lessor is free to use the initiation fee received, immediately, for any purpose.
Other varieties of the initiation fee concept include the so-called "move-in" fees that some residential property lessors require. These may include such items as a "key fee," "lock-change fee," or "initial cleaning and painting fee."
Lessors sometimes include in the leasing contract a the requirement for an up-front security deposit. In principle, lessors are obligated to return the deposit, with interest, at the end of the lease—except under certain contingencies. The contract may enable the lessor to keep some or all of the security deposit to cover such things as excessive wear or damage to the property, unpaid or late regular leasing payments, or legal fees if the lessor must legally evict the lessee or sue to recover damages.
For some kinds of leased property, such as automobiles, lessors sometimes include a disposal fee to be paid at the end of the lease life. These funds are meant , ostensibly, to prepare the returned property for re-sale or leasing again to another party. With leased automobiles, it is common practice for the lessor to excuse (waive) the disposal fee if the lessee actually buys the vehicle after the lease contract.
Early Termination Fees
One difference between ordinary rental contracts and leasing contracts for the same property, is the ease with which the contract holder can exit or "break" the contract.
- For contracts that are truly rental agreements, the property user can legally exit the contract at any time if the payments are current, and if the property is returned immediatley in good conditions.
- For lease contracts, however, the lessor may require the lessor who declares an early contract exit to pay immediately all remaining scheduled payments that would be due through the contract life. The lease contract may also specify a substantial early termination fee, in addition to all other payments due.
Payment Timing vs. Payment Total
Businesspeople considering a proposed leasing offer—especially those facing a Lease vs. Buy decision—are well advised to review and consider carefully both the total amounts and the timing of lease payments.
In some cases, total costs for a long term lease may seem excessively high. Or, total lease costs may exceed total cost of ownership for purchasing the same property. Nevertheless, the timing of payments required over the life of the lease may make the lease offer a more attractive proposition.
Very briefly, this is because leasing tends to level payment cash flow across a long lease contract life, whereas the cash flow profile from a comparable purchase will probably be "front-loaded." For more on the role of payment timing in making lease decisions, see the section below Lease vs. Buy Decision.
International and National standards classify most leases in as belonging to one of two categories: Operating leases or Capital leases.
An operating lease contract is similar to a rental contract: The lessee pays fees for the life of the lease and simply uses the property (for example, a computer system, or a vehicle). The lessee reports these costs as operating expenses (thereby lowering reported income and tax obligations), but takes no depreciation expense. The lessor (owner), however, can claim depreciation expenses and take tax benefits.
When the operating lease term is over, the lessee surrenders the property (or renews the lease, or perhaps has an option then to purchase outright). Operating leases differ from rental contracts, primarily in that leases are more binding (have bigger penalties for early canceling), and usually cover longer terms. An operating lease generally covers a time period significantly less than the expected life of the leased goods.
Note especially that many airlines choose to acquire aircraft through operating leases rather than outright purchase. The purpose, of course, is to keep some very expensive assets off of the Balance sheet. As of 2017, for instance, the Economist and other sources estimate that roughly 40% of the world's passenger airliners are leased rather than owned by their operators. Many operate fleets that include both leased and owned aircraft. Operators including Delta, Air Canada and Air New Zealand, for instance, lease a major part of their fleets.
Capital leases are more like financed purchases, that is, under the terms of the lease, the lessee may immediately gain some of the benefits of ownership, such as charging depreciation expense (and taking tax benefits from that), and recognize the asset on the Balance sheet as a capital asset.
Lease Classification is All About Ownership
The distinction between operating leases and capital leases (financing leases) has important financial consequences for both lessor and lessee. Classifying a lease as either capital lease or operating lease determines:
- Which party (lessor or lessee) has ownership rights.
- Who claims depreciation expense for the leased property,
- Who can treat lease costs as expenses.
- Other country-specific rights and obligations
Standards for Lease Classification
The full set of criteria for differentiating between lease classes is specified in country-specific standards. The standards for several English-speaking countries are the following:
- For US-based lessors and lessees, a leases are classified with reference to criteria stated by US Financial Accounting Standards Board Ruling 13 (FASB 13).
- The operative standard for lessors in Australia, Canada, New Zealand, and the United Kingdom, the operative guide is International Financial Reporting Standard 16 (IFRS 16).
- For lessors and lessees in India, the operative standard is Institute of Chartered Accountants of India (ICAI) accounting standard 19 (AS 19).
US FASB 13 Classification
The United States Financial Accounting Standards Board statement 13 (FASB 13) provides the US definitions and criteria for deciding whether or not a lease agreement is to be considered a purchase/sale agreement (and therefore a capital lease) or a usage agreement (and therefore an operating lease).
For proper explanation of FASB 13 criteria and usage or usage of standards from other countries, consult a leasing guide or financial textbook. Very briefly, FASB 13 states that a lease will be considered an operating lease (usage agreement) unless one or more of the following four criteria are met. If any of the following applies, the lease is then treated as a capital lease (purchase/sale agreement):
- The lease automatically transfers ownership of the property to the lessee by the end of the lease.
- The lease contains a bargain purchase option.
- The lease term equals 75% or more of the estimated economic life of the property.
- The present value of the minimum lease payments at the beginning of the lease term equals or exceeds 90% of the fair market value of the property.
Note also that In 2016, the US FASB amended accounting rules to require companies to capitalize all leases with contracts extending one year or more on their financial statements
Lease vs. Buy: Which is the Better Business Decision?
For large companies, the manner by which the firm acquires major assets can have a significant impact on the firm's long term financial performance and position. This reality is center stage when companies decide how best to expand or replace assets such as the following:
- Vehicle fleets (for example, automobiles, delivery vans or trucks).
- Transport fleets (e.g., passenger aircraft, cargo aircraft, city buses or school buses).
- Heavy construction equipment (such as cranes, bulldozers, or backhoe loaders).
- Buildings (e.g., Office space, retail selling space, manufacturing space).
Company officers are challenged to choose an acquisition method by identifying the "better business decision" among options such as these:
- Cash purchase
- Financed purchase (with, for example, a bank loan or bond issue).
- Leasing (Capital lease or operating lease).
An individual, deciding how best to acquire a new car, may very well address the "Lease vs. Buy" question, suitably, with a few "back-of-the-envelope calculations. The individual will probably decide to lease or buy on the basis of total cost estimates and the timing of payments under each option.
When large companies plan to acquire major long term assets, however, decision makers are well advised to look beyond total costs and payment timing, and consider as well how each option impacts long term operational performance, earnings, asset performance metrics, and the company's capital structure. Finding the better business decision, in other words, calls for a serious, in-depth business case analysis
Interrelated Decisions in Lease vs. Buy
Consider, for example, a passenger airline considering expanding the size of its aircraft fleet. This situation in fact raises several kinds of decisions:
- Firstly, shall the carrier expand the fleet or should it decide not to expand?
- Secondly, If management decides to expand, then, secondly, by how much should they expand capacity? And, which kinds of aircraft should they choose to meet forecast capacity needs?
- Thirdly, if management is comfortable with its answers to the first and second questions, they must ask: How should we acquire the aircraft?
For a large firm in a competitive industry, exactly how the firm answers each such question can impact on the firm's long term operational and financial performance. In cases of this kind, facing several important, interrelated decisions, finance officers and other managers normally turn to business case analysis (BCA) for credible guidance and decision support.
In brief, business case analysis can be defined as a decision support and planning tool that projects the likely financial results and other business consequences of an action or investment. The analysis essentially asks: “What happens if we take this or that action?" The BCA answers in business terms—business costs, business benefits, and business risks.
When the case must serve decision support needs—as in this example—the firm creates and analyzes several business case scenarios, each of which assumes specific answers to all three kinds of questions (Shall we expand? By how much? And, how should we pay for this expansion?). The example airline, for instance, might create a business case with the following scenarios that it considers likely candidates for implementation:
- Large capacity expansion, acquired with operating lease.
- Large capacity expansion, acquired with cash purchase
- Large capacity expansion, financed with bank loan.
- Small capacity expansion, acquired with cash purchase.
- Business as Usual: No expansion. Continue operating with existing fleet.
The analyst will then project financial and non financial outcomes under each scenario. Decision makers will evaluate and compare scenario outcomes by quite a few different financial metrics and other criteria. Deciding which scenario represents the better business decision becomes a matter of deciding which scenario has the most favorable aggregate score, on the full set of outcome metrics.
Notice especially that the decision support business case almost includes a "Business As Usual, " or "Baseline" scenario. This scenario projecting cost and benefit results for the firm in the case that it decides ultimately to implement none of the action scenarios. This scenario will be analyzed even if in situations where not taking action (such as expanding capacity) is unthinkable. The baseline case is necessary in order to measure incremental changes in costs and benefits that would follow under any of the other action scenarios. And, in some cases, businesspeople are surprised to discover that "Business as Usual" actually turns out to be the better business decision.
Lease vs. Buy Scenario Cash Flow Estimates
Scenario comparison provides useful guidance for decision support, only if all scenarios are comparable to each other. This means that the analyst measures the same set of costs and benefits, for all scenarios, including "Business as Usual."
For business case analysis, all financial results and analysis are based on cash flow estimates. Exhibit 1, below, for instance, shows the form and contents of scenario cash flow statements the example airline might use. Each scenario cash flow statement will have exactly the same line items: Only the actual estimated cash flow numbers will differ among scenarios.
Some items may yield "$0" estimates for some items: Leasing fee estimates, for example, would be $0 for the Purchase Scenario, while Capital acquisition Costs would probably be $0 in the Lease Scenario.
Exhibit 1. Cash Flow estimates for one business case scenario--in this case the lease proposal scenario. All business case scenarios have exactly the same line items and structure.