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Operational vs. Financial Leasing

Leasing is nothing more than a method of paying for the use of a vehicle, equipment, building or other asset over a specified period of time. It might sound like renting, but is not since they are very different. While the companies or natural persons can rent a car for as little as a day, or even a few hours, leasing typically starts at 24 months and doesn't provide for easy termination or vehicle swapping.

Leasing has become one of the major sources of capital formation in the country in recent years. The decision of a company to lease or buy equipment is a complex one involving tax regulations, accounting principles, debt structure impact, financing choices, credit lines, and other important factors.
This increasing activity in the leasing area has resulted in bank participation as a growing portion of the business.
Why is Leasing so popular?
Leasing has become popular in recent years because there has been a trend focusing on the ability to use property rather than on the legal ownership of property.
Other reasons often mentioned include the sharing of tax benefits between lessors and lessees. However, the big incentive for leasing continues to be its nontax attributes. These include flexibility of leases, leasing as a hedge against obsolescence and inflation, servicing and maintenance contracts, convenience, cheaper costs (economies of scale), off balance-sheet financing (when the lease does not appear on the face of the balance sheet), and a simple inability to obtain the financing to buy.
As it was already known, there are two ways of accounting for leases. In an operating lease, the lessor (or owner) transfers only the right to use the property to the lessee. At the end of the lease period, the lessee returns the property to the lessor. Since the lessee does not assume the risk of ownership, the lease expense is treated as an operating expense in the income statement, and the lease does not affect the balance sheet. Also, the operating lease is that financing agreement where the term of the lease is shorter than the actual useful life of the leased object.
In a capital or financial lease, the lessee assumes some of the risks of ownership and enjoys some of the benefits. Consequently, the lease, when signed, is recognized both as an asset and as a liability (for the lease payments) on the balance sheet. The company gets to claim depreciation each year on the asset and also deducts the interest expense component of the lease payment each year. Generally, financial leases recognize expenses sooner than equivalent operating leases.
Since companies prefer to keep leases off the books and sometimes prefer to defer expenses, there is a strong push from companies’ side to report all agreements as operating leases. Usually, a lease should be treated as a capital lease if it meets any one of the following four conditions:
  • If the lease life exceeds 75% of the life of the asset;
  • If there is a transfer of ownership to the lessee at the end of the lease term;
  • If there is an option to purchase the asset at a "bargain price" at the end of the lease term;
  • If the present value of the lease payments, discounted at an appropriate discount rate, exceeds 90% of the fair market value of the asset.
When a lease is classified as an operating lease, the lease expenses are treated as operating expense and the operating lease does not show up as part of the capital of the company. When a lease is classified as a capital lease, the present value of the lease expenses is treated as debt, and interest is imputed on this amount and shown as part of the income statement.
In practical terms, however, reclassifying operating leases as capital leases can increase the debt shown on the balance sheet substantially, especially for companies in sectors which have significant operating leases, such as airlines, retailing or distribution.
Therefore, the operating lease payments are just as much a commitment as lease expenses in a capital lease or interest payments on debt.
Operational leasing is often sold as a set of services, such as asset financing, but also including full coverage of all asset management aspects. When applied to vehicle lease, these services range from additional consumables to regular maintenance in the form of fleet management outsourcing, which usually includes tires, insurance, replacement vehicle, service and other.
Benefits of lease agreements
Deciding whether a financial or operating makes sense for a company depends on its business needs and context on the decision time.
If the equipment, vehicle or real estate asset will not be used on long-term, if it will be outdated quickly and the company wants to protect its cash and balance sheet, then the operating lease is the right choice, namely:
  • Manage cash flow — operating leasing avoids large out-of-pocket expenditures. Low monthly payments help the company better manage its cash flow to keep the business growing;
  • Tax advantages — Payments are considered operating expenses and are fully tax-deductible;
  • Refresh technology or brand new assets — at lease-end, the company has the option to "trade up" to new equipment / vehicle for keeping its business competitive;
  • Flexible terms and structures;
  • Flexible lease-end options — at the end of the lease term, the company has several options available depending on its business needs:
  • Renew the lease at a lower rate,
  • Return asset with no further obligation,
  • In case of equipment, upgrade it to take advantage of new technologies.

Particularly in this sensitive economic time, this financing product is the choice for both parties; they are more cautious, no longer allow surprises in budget risk-taking and try to cut costs as much as possible.

In the automotive market, by choosing operating lease, the customer knows exactly how much the fleet costs, has full control over the costs and pays only for what he uses. The lessee benefits from a lower monthly installment, increased flexibility and the ability to restructure the product based on its business needs (estimated number of kilometers per year, usage period and car model).

From the viewpoint of the user, it is just about the same as equipment leasing, except it's for an intangible, the software and the software license. It is a method of paying for software over time instead of a single upfront payment and the functional equivalent of a loan from the leasing company or the software developer. It is normally structured as a capital lease rather than an operating lease. However, it is often accounted for as an operating lease.
For users it will be much easier to:
  • Obtain all the licenses that are needed now to supply all users; You have funds allocated in your budget for only some of the licenses you need. You can arrange a lease for all the licenses you need and still be within your annual budget requirements.
  • Include consulting, hardware, customization, and training costs in the lease; Bundling the individual components of a project in one lease is normally simpler and tends to result in level expensing rather than having some components expensed upfront before benefits are realized;
  • Include internal implementation costs in the lease where appropriate. You're doing some of the work, like data conversion. These costs also be included in the lease;
  • Own the license at the end of the lease without additional payment. In fact, unless you clearly have only a short-term need for the software, you should only execute a finance lease where there are no additional payments at the end of the lease. We think the value of software at the end of the lease is in most cases close to, if not greater, than the value at the beginning. Thus, an operating lease with an option to purchase at fair market value option at the end of the lease will in almost all cases turn out to an expensive proposition;
  • Correct the failure of many accounting systems to recognize the long-term benefits of software and related costs. A lease will in most cases permit you to better match software expenses with the period of benefit.
For vendors, the benefits will include:
  • Hardware, training, installation, and customization in the lease; Bundling the individual components of a project provides your customer with one-stop shopping and avoids expensing some items upfront before benefits are realized;
  • Obtain a strategic competitive advantage over competitors which do not offer leasing alternatives to your customers;
  • Neutralize the strategic competitive advantage of competitors which offer leasing alternatives to your customers;
  • Offer leasing options to your affiliates. Leasing programs can be expanded beyond your direct sales force;
  • Realize the potential for additional licenses for additional users, licenses for related products, and additional charges for installation, training and customization that customers require;
  • A master lease agreement with one-page add-on leases allows you to offer users additional products with minimal financing effort by the user.



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