Fri. Aug 12th, 2022
    Leasing | Types, Explanations and Examples

    Leasing

    Leasing is a financial contract for acquiring or using movable property (property that can be moved from one place to another: car, professional equipment, watches, jewellery) or immovable property (land, real estate, warehouse, manufacturing plant), without borrowing money in a classical way. For example, a company acquiring a car or professional equipment on lease pays rent to use the goods acquired. At its end, may include a purchase option, a renewal of the contract or the return of the equipment.

    How does leasing work?

    Leasing is a device that involves three parties:

    1. The seller of movable or immovable property;
    2. The buyer/tenant signing the leasing contract;
    3. The leasing company.

    In concrete terms, the leasing company buys the movable or immovable property from the seller then rents it to the purchaser, who thereby becomes the “tenant” of the property and who therefore pays rent to the leasing company in return for the use of the Good.

    There are two types of leasing:

    Rental with Option to Purchase: with this leasing format, at the end of the leasing contract, the user has the possibility of buying the asset at a price determined at the signing of the contract;
    Rental Without Purchase Option: with this format, at the end of the leasing contract, the user is required to return the equipment used to the leasing company, even if it means taking out a new contract (an option generally chosen when the movable property used needs to be changed regularly).

    Advantages and disadvantages of leasing

    Leasing, for example, allows a company to acquire or at least use (since the leasing company remains the owner of the asset) a car, a commercial vehicle or professional equipment without investing and without borrowing, which reduces the personal contribution necessary to create a business.

    Why is leasing better than another method of financing?

    Leasing is a much more attractive method of financing than all other forms of car financing. It is economical, flexible and secure.

    The leasing with option to buy is generally more economical than a traditional method of financing. The rental of the car and the optional guarantees covering its repairs and maintenance throughout your commitment are often more advantageous than the monthly repayments of a loan that does not take into account these maintenance charges.

    Lease with option to buy is also flexible. First of all, you are free to pay a contribution or not. Then you can modulate the different criteria (duration of the contract, mileage package, contribution, options) according to the amount of rent you wish to obtain. You also have the possibility of modifying the duration and the number of estimated kilometers during the contract. Finally, with the purchase option, you are free to buy your car at the price defined at the time of signing or to return it at the end of the contract.

    Finally, the leasing with option to buy is secure financing. Indeed, the amount of the rent defined at the signing of your leasing contract is fixed throughout your commitment. You therefore have a precise vision of your investment and can anticipate your expenses. Leasing is also secure thanks to the Reliable or refunded options, the Mechanical warranty and the maintenance contract. By integrating these optional services, you combine all the costs of using and operating your car in a single monthly payment for maximum peace of mind and safety when traveling.

    The different categories of leasing

    1. Operational

    It allows the financing of current medium-term investments, such as the acquisition of vehicles, machinery or movable property. Operational leasing includes service and maintenance elements. The cost of maintenance and repairs is included in the rent and, in the event of equipment problems during the term of the contract, it will be replaced, at no additional cost.

    2. Financial (also known as a capital lease or a sales lease)

    It allows you to rent a property over the long term. Unlike operational leasing, this format does not include any services. Which is where the leased asset is capitalized on the balance sheet with the lessee. The duration generally corresponds to the amortization period of the asset in question and the acquisition-oriented (financial) operation. For example, a manufacturing company can obtain a piece of production machinery for their operations through a capital lease. Misalnya, sebuah perusahaan manufaktur dapat memperoleh sepotong mesin produksi untuk operasi mereka melalui sewa modal atau financial lease. Example of lease financing for equipment is generally provided by banks, captives and independent finance companies.

    Factoring

    It purchases the notes and accounts receivables from customers on a nonrecourse basis. In the event receivables cannot be collected due to cases such as bankruptcy of the original debtor, our customer is not obligated to buy back the receivable, contrary to bill discounting. Factoring allows our customers to hedge credit risk of the original debtor, streamline their balance sheets, improve cash flow, and diversify fund procurement.

    For example, the leasing company can purchase notes and receivables from customers on a nonrecourse basis. In the event that the receivables are uncollectible due to cases such as bankruptcy of the original debtor, their customers are under no obligation to repurchase the receivables, as opposed to purchasing invoices at a discount. Factoring enables our customers to be hedged against credit risk value of the original debtor, streamlining balance sheets, increasing cash flow and diversifying funding procurement.

    Impact on accounting

    Since a finance lease is capitalized, both assets and liabilities in the balance sheet increase. As a consequence, working capital stays the same, but the debt/equity ratio increases, creating additional leverage.

    Read also: Liquidity Ratio (Accounting) Formulas, Examples, Questions, Answers

    Finance lease expenses are allocated between interest expense and principal value much like a bond or loan; therefore, in a statement of cash flows, part of the lease payments are reported under operating cash flow but part under financing cash flow. Therefore, operating cash flow increases.
    Under operating lease conditions, lease obligations are not recognized; therefore, leverage ratios are understated and ratios of return (ROE and ROA) are overstated.

    In the USA

    Under US accounting standards, a finance (capital) lease is a lease which meets at least one of the following criteria:

    • ownership of the asset is transferred to the lessee at the end of the lease term;
      the lease grants the lessee an option to purchase the asset and the lessee is reasonably certain to exercise the option;
    • the lease term is for the major part of the remaining economic life of the underlying asset (75% of the asset’s estimated useful life or greater);
    • the present value of the lease payments and any residual value guaranteed by the lessee equals or exceeds substantially all of the fair value of the asset (90% of the total original cost of the equipment).

    The asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.
    Following the GAAP accounting point of view, such a lease is classified as essentially equivalent to a purchase by the lessee and is capitalized on the lessee’s balance sheet. See Statement of Financial Accounting Standards No. 13 (FAS 13) for more details of classification and accounting.

    3. Real estate

    It consists of financing the construction of real estate for professional use or the purchase of an existing building. It can also be offices.

    Leasing is a very interesting financing solution for all companies. This is an effective way to acquire equipment without straining the company’s budget. It thus makes it possible to preserve the borrowing capacity of the company for other investments. It is common to use it to equip its staff with a company or company car, or to finance industrial machinery.

    Most common types of commercial real estate leases include:
    • Single-Net Leases: In this kind of lease, the tenant is responsible for paying property taxes.
    • Double-Net Leases: These leases make a tenant responsible for property taxes and insurance.
    • Triple-Net Leases: Tenants who sign these leases pay property taxes, insurance, and maintenance costs.
    • Gross Leases: Tenants pay rent while the landlord is responsible for other costs.
    4. Sale and leaseback

    Sale and lease back is an operation by which a company transfers part of the capital goods it owns to a leasing company, which then immediately leases them back to it. This usually happens in the form of financial leasing. For example, this financing is done by buying assets in the form of machines or equipment owned by the customer and then rent to work back to the customer, so that the customer can continue to use the assets that have been sold and also get funds equal to the price of the assets sold.

    5. Vendor

    These are suppliers of movable capital goods (movable capital such as cars, money) whose business model automatically provides for the conclusion of a lease or leasing contract. In general, other related services are also offered (such as insurance and property maintenance) under or without a lease or lease contract. This contract or the receivables arising from this contract are transferred by the supplier, with a view to refinancing, to the leasing company, with or without ownership of the equipment that is the subject of it.

    Sources: PinterPandai, KnowledgeBrief, eFinanceManagement

    Photo credit: kschneider2991 / Pixabay via Wikimedia Commons (CC BY-SA 4.0)