Question

"Operating and Capital Leases" Discuss recommendations you would make to chief financial officers (CFOs) of retailers, service providers, and other businesses that lease several locations or have substantial leases of real estate or other assets. Indicate the pros and cons of each approach. Is leasing a better option that buying/selling? Discuss the advantages and the disadvantages of leasing for a lessee. Discuss the advantages and the disadvantages of leasing for a lessor

Answer 1

CAPITAL LEASE

If you have an agreement in which you will own the item at the end of the lease agreement — also know as a lease-to-own agreement — then the lease is a capital lease.

Another capital lease situation is when you’re given the option to purchase the item at a discount at the end of the leasing term. If you have this option, then your lease is a capital lease.

A capital lease can also be defined by other factors. If the present value of your lease payments is greater than 90 percent of the item’s fair market value, then you have a capital lease. For example, if you lease a truck valued at $50,000 for 48 months and pay $975 a month, then the value of your lease is $46,800, which is 93.6 percent of $50,000, making it a capital lease. Similarly, if you have a lease that lasts for at least 75 percent of the item’s estimated useful life, then your lease is a capital lease.

OPERATING LEASE

An operating lease can be defined essentially as a lease agreement in which there is no element of ownership in regard to the leased item. Thus, if you have a lease in which there is no transfer of ownership at the end of the agreement — so it is not a lease-to-own arrangement — then the lease is an operating lease. If there’s also no option to purchase the leased item at the end of the lease term, then it is an operating lease.

Similarly, if the value of your lease payments is equal to less than 90 percent of the item’s fair market value, then the arrangement is an operating lease. And if your lease terms are shorter than 75 percent of the item’s estimated useful life, then you have an operating lease.

With the fundamentals of a capital lease versus operating lease laid out, you can now figure out which lease arrangement works best for you. In the end, your decision depends largely on the types of assets you need for your business and the role it plays in business operations.

Pros and Cons of a Capital Lease

Perhaps the best feature of a capital lease is the ability to try out the asset before you buy it. This is great if you’re undecided on the practical value of an asset and don’t want to commit to an outright purchase of the item before you know its worth. If the item turns out not to be worth it, then you can decide against purchasing the item at the end of the lease. And if the leased item does prove worth it, with a capital lease you can then take on ownership. What’s more, you can use interest expenses on a capital lease to reduce your taxable income.

The main drawbacks with a capital lease relate to its cost and risks involved with ownership. In terms of cost, with a capital lease, you can often end up paying more in lease payments than in buying the asset right away or in payments for a typical loan agreement. Since capital leases grant aspects of ownership, you take on the associated risks. For example, if you have a capital lease on a major piece of equipment, then you’re responsible for its repair and maintenance costs.

Other minor downsides of a capital lease relate to taxes. Specifically, capital lease payments are not tax-deductible expenses, though the interest on payments is deductible. Although with many leases, the lessee can claim depreciation on the asset to reduce taxable income, some leases are not eligible for depreciation allowances on your taxes.

Pros and Cons of an Operating Lease

Many of the benefits of an operating lease come from potential savings. With operating leases, you can rent equipment that is too expensive to purchase. Like a lease from a car dealership, with an operating lease, costs for repairs and maintenance are often covered by the lessor, which can be very useful for equipment that requires significant upkeep. From a tax standpoint, operating leases are beneficial because lease payments are tax-deductible expenses.

Another benefit of operating leases is that accounting for them is generally easier than the accounting for a capital lease. Namely, most operating leases have terms of 12 months or less, with payments simply recorded as expenses on your profit and loss statement. Capital leases also have accounting features that are a bit more involved than what needs to be done for an operating lease, such as creating an additional liability account called Capital Lease Payable.

The main drawback of an operating lease is due to the lack of ownership at the end of the lease agreement. And as with capital leases, there is the danger that you will end up paying more in lease payments than you would if you purchased the asset, even if it required taking out a loan to do.

Buying

When you purchase something from a seller, you officially own the item (or the bank does if you have borrowed the money). Once the transaction has been made and the papers have been signed, the seller no longer has ownership over the asset.

Leasing

Leasing on the other hand is an agreement between the lessee (you) and the lessor. You have access to the asset, usually against periodic payments, but the lessor still has ownership over the item. After the completion of the lease, you often have the choice to hand the asset back, or transfer the ownership to you for a final lump payout.

So which option is the better alternative?

This is entirely dependent on your financial position and individual circumstances. Some assets also require regular services, repairs or inspection, therefore this must be taken into account when securing a deal.

Lease Vs. Buy Analysis

Pros and cons of buying

• If the asset in question is for long-term use, typically buying tends to be the cheapest option when it comes to out-of-pocket expenses.
• Purchasing may be the better option for you if your business has the sufficient funds available to pay outright without interfering with your other financial obligations.
• There is often room for flexible payment options when purchasing a product, such as bank loans or repayments.
• Having ownership over an asset with a value that is predicted to rise can offer a great investment opportunity.
• If your are purchasing a depreciating asset, it is worth thinking about just how much you are going to actually use it. If it’s had very little benefit to you over the years, you could end up wasting a lot of money when it comes to selling it further down the line.
• The cost of buying soon outweighs the cost of leasing if you find yourself repeatedly letting the asset for short-term periods.
• If you do decide to buy the asset through the assistance of a loan, you also need to take into consideration any additional costs such as interest rates.

Pros and cons of leasing

• Leasing frees up your capital for other, more important, purchases.
• Leasing gives you access to the latest and greatest equipment, as and when it becomes available on the market.
• The leasing supplier often carries out any services or repairs that are required, meaning future costs are predictable and you don’t have to worry when things go wrong with the asset.
• The downside to leasing is you don’t actually own the asset. If you find yourself requiring the item again in the future, leasing can end up costing your company more in the long run.

Leasing to the Lessee (User of Asset)

Advantages

1. No Need of Initial Investment

2. Suitable and Easy Source of Finance

3. Generally, time taken to process the lease proposal is lesser than the term-loan financing This helps the firm/lessee to possess the right to use the asset or the property with no or less delay.

4. Faster and Simple Documentation Procedure

5. If the lessee/firm does not require the use of asset till the end of lease period, the lease can be terminated in the middle in case of operating or service lease

6. Less Maintenance Costs   

7. It is quite beneficial for the lessee in reducing the tax liabilities as the lease rentals are regarded as revenue expense.The lease rentals can be adjusted by the lessee so that it helps in planning the taxes and reducing the tax liabilities.

8. The risk of disuse of the asset or property is on the shoulders of the lessor as he is the owner of the asset. The lessee can replace the asset anytime with the latest and updated technology.

Disadvantages

1. In case of deterioration in the financial position of the lessor or winding up of leasing company, the use of asset may be deprived to the lessee.

2. Loss of Ownership Incentives

3.  No Permission to Renovate

4.  Loss in the Salvage Value of Asset

5. If the lessee terminates the lease before its time period, certain penalties may be incurred upon by the lessor.

6. For the lessee, the lease rentals include a margin as the cost of risk of disuse of the property. which is why it is regarded as a form of financing at a higher cost..

Leasing to the Lessor (Owner of Asset)

Advantages

01. Quick & Higher Profits  The lessor receives lease rentals from the lessee which help in making high profits. The rate of return is quick and more than what the lessor pays on his borrowings for acquiring such assets.

2.Security  If the lessee fails to pay the lease rentals, the lessor can repossess the leased asset, property or equipment, the lessor interest is secured here.

3.  Tax Benefits Lessor being the owner of the asset can claim various tax related benefits such as depreciation, incentives on investment, etc.Depreciation is deducted from the income. Less is the income, less is the tax laid on it.

4. When manufacturers increase their sales with the help of lease financing through third parties, the lessor can also demand certain benefits from the manufacturers.

Disadvantages

1. The lease rentals are generally fixed throughout the lease period so if there is any increase in the prices of the assets due to inflation, there is no benefit to the lessor.

2. Increased Cost Due to User Benefit’s Loss  The benefits which are available to the users of asset such as concession in GST/ VAT, duties, etc. are not available to

3. Long-Term Investment  The capital outlays earned through lease rentals usually takes a long time to recover the cost of the lessor.

4. High Risk of Obsolescence  In the present times of rapid changing technology, there is risk of obsolescence (state of being unused) of technical equipment which also lies on the shoulders of the lessor.