Lease finance

What Is Lease Finance?

Lease finance, falling under the broader category of corporate finance, is a method of acquiring the use of an asset for a specified period in exchange for regular payments, without necessarily transferring ownership. It is a contractual arrangement where one party, the lessor (owner of the asset), grants the right to use the asset to another party, the lessee (user of the asset), for a set term. This financial mechanism allows businesses and individuals to utilize essential assets, such as equipment, vehicles, or real estate, without the upfront capital expenditure of a direct purchase. Lease finance is a widely adopted alternative to debt financing for asset acquisition.

History and Origin

The concept of leasing has roots dating back thousands of years, with evidence of equipment leasing and finance in ancient civilizations.³⁶ However, the modern form of lease finance gained significant traction in the 20th century, particularly in the United States, with the expansion and diversification of the equipment finance industry.³⁵ The Equipment Leasing and Finance Association (ELFA), a trade association representing the U.S. equipment finance sector, was founded in 1961 as the Association of Equipment Lessors.³⁴,³³ This period saw the introduction of various tax laws and regulations that shaped the industry, aiming to stimulate economic activity and capital expenditure.³²

A pivotal development in lease accounting occurred with the issuance of Accounting Standards Codification (ASC) Topic 842, "Leases," by the Financial Accounting Standards Board (FASB) in 2016.³¹ This new standard aimed to enhance transparency by requiring lessees to recognize most leases on their balance sheets, addressing previous "off-balance-sheet financing" concerns associated with operating leases.³⁰,²⁹ Public companies adopted ASC 842 for fiscal years beginning after December 15, 2018, with private companies following suit for fiscal years beginning after December 15, 2021, after some delays due to complexities and the COVID-19 pandemic.²⁸,²⁷

Key Takeaways

• Lease finance allows the use of an asset without immediate ownership, offering an alternative to direct purchase.
• It involves a lessor (asset owner) and a lessee (asset user) in a contractual agreement.
• Lease finance can preserve capital and offer tax advantages, depending on the lease type and jurisdiction.
• Recent accounting standards, such as ASC 842, require most leases to be recognized on the balance sheet, increasing financial transparency.
• Two primary types of leases for lessees under current accounting standards are finance leases and operating leases.

Formula and Calculation

The core of lease finance calculations involves determining the present value of lease payments to establish the lease liability and the corresponding right-of-use (ROU) asset on the lessee's balance sheet under accounting standards like ASC 842.

The formula for the present value of lease payments (PV) typically considers the periodic lease payment (PMT), the discount rate (r), and the number of periods (n). The discount rate is often the implicit rate in the lease or the lessee's incremental borrowing rate.

Where:

• (PV) = Present Value of Lease Payments (Lease Liability)
• (PMT_t) = Lease payment in period (t)
• (r) = Discount rate
• (t) = Period number
• (n) = Total number of periods in the lease term

This calculation forms the basis for recognizing the initial lease liability and ROU asset.

Interpreting the Lease Finance

Interpreting lease finance involves understanding its impact on a company's financial statements and overall financial health. For lessees, the implementation of ASC 842 significantly altered how leases are reported. Previously, many operating leases were "off-balance-sheet," meaning only the lease expense was recognized on the income statement.²⁶ Now, both a right-of-use (ROU) asset and a lease liability are recorded on the balance sheet for virtually all leases, including operating leases, with terms greater than 12 months.²⁵,²⁴

This on-balance-sheet recognition provides a more transparent view of a company's obligations and its true financial position. For instance, an increase in lease liabilities can impact key financial ratios, such as debt-to-equity, which analysts and lenders use to assess a company's leverage and creditworthiness. While some observers have noted that this can make comparability challenging, the additional information ultimately allows for better assessment of a company's operations.²³ For lessors, the accounting remains largely consistent with prior standards, classifying leases as operating, sales-type, or direct financing leases.²²,²¹

Hypothetical Example

Consider "Tech Solutions Inc.," a company that needs new servers for its data center. Instead of purchasing them for $500,000, which would require a significant upfront capital outlay and potentially impact its cash reserves, Tech Solutions Inc. decides to enter into a lease finance agreement.

The lease agreement is for five years with annual payments of $110,000, payable at the beginning of each year. The implicit interest rate in the lease, or Tech Solutions' incremental borrowing rate, is 5%.

Using the present value formula, Tech Solutions Inc. would calculate its initial lease liability and ROU asset.

For the sake of simplicity, let's look at the first year's impact. The initial ROU asset and lease liability would be the present value of the five annual payments. After the first payment, the liability would be reduced, and the ROU asset would be amortized. The total lease expense recognized on the income statement would depend on whether it's classified as a finance lease (interest and amortization expense recognized separately) or an operating lease (single straight-line lease expense). This allows Tech Solutions Inc. to acquire and use the necessary technology while spreading the cost over time and maintaining liquidity.

Practical Applications

Lease finance is a versatile financial tool with numerous practical applications across various industries and for different types of assets. Businesses frequently use lease finance to acquire equipment such as machinery, vehicles, and technology, enabling them to upgrade and adapt without significant capital expenditure. For example, a construction company might lease heavy machinery, or a healthcare provider might lease specialized medical equipment, thereby preserving capital for other operational needs or investments.

In the real estate sector, companies often engage in commercial property leases, allowing them to secure office space, retail locations, or industrial facilities without the extensive commitment and upfront costs of purchasing the properties outright. This can provide flexibility, particularly for businesses that anticipate growth or changes in their operational footprint.

Regulatory changes, specifically ASC 842 in the U.S., have brought more transparency to lease accounting by requiring nearly all leases to be recognized on a company's balance sheet as both a right-of-use asset and a corresponding lease liability.²⁰,¹⁹ This has significantly impacted financial reporting and analysis, as it provides a more comprehensive view of a company's financial obligations. For example, Thomson Reuters has noted that investors are now better able to assess companies' business operations due to the increased transparency regarding lease obligations.¹⁸

Limitations and Criticisms

Despite its benefits, lease finance, particularly under the current accounting standards, has limitations and has faced some criticisms. One significant concern, especially during the transition to ASC 842, was the complexity and resource intensity of implementation. Many companies, particularly private ones, found the process of identifying embedded leases, establishing appropriate discount rates, and integrating new accounting systems to be time-consuming and challenging.¹⁷,¹⁶ The shift from off-balance-sheet operating leases to on-balance-sheet recognition also means that a company's assets and liabilities are expected to increase, which could impact key financial ratios and potentially affect existing or future debt covenants.¹⁵

While the increased transparency of lease obligations on the balance sheet is generally viewed as beneficial for investors, some financial reports may lack comparability across companies or even within the same company over different periods due to the complexities of the new standard.¹⁴ There were initial concerns, for instance, about the potential for accounting changes to negatively impact the economy by forcing companies to cut back on spending to maintain debt ratios.¹³ However, the Financial Accounting Standards Board (FASB) has worked to address these issues, including providing deferrals for the effective date for private companies and issuing amendments to simplify certain aspects of the rules.¹²,¹¹

Lease Finance vs. Debt Financing

Lease finance and debt financing are both methods for businesses to acquire and utilize assets, but they differ fundamentally in terms of ownership, financial reporting, and flexibility.

The primary distinction lies in ownership and how the transaction is reflected on the financial statements. With debt financing, the borrowing entity directly owns the asset, and the loan represents a financial obligation. In lease finance, particularly a finance lease under ASC 842, the lessee recognizes an ROU asset and a lease liability, treating it economically similar to a financed asset purchase, while an operating lease results in a single straight-line lease expense on the income statement in addition to the balance sheet recognition.⁹,⁸ This means that while both methods increase a company's liabilities, the nature and presentation of these liabilities differ.

FAQs

What are the two main types of leases under ASC 842?

Under ASC 842, for lessees, leases are primarily classified as either finance leases or operating leases. This classification determines how the lease expense is recognized on the income statement, although both types generally require the recognition of a right-of-use (ROU) asset and a lease liability on the balance sheet.⁷,⁶

Why did accounting standards for leases change?

The accounting standards for leases changed, particularly with the introduction of ASC 842, to enhance transparency in financial reporting. Previously, many operating leases were not reported on the balance sheet, which obscured the true extent of a company's lease obligations. The new standards aim to bring most leases onto the balance sheet, providing investors and other stakeholders with a more complete picture of a company's assets and liabilities.⁵,⁴

Is lease finance suitable for all businesses?

Lease finance can be suitable for many businesses, but its appropriateness depends on various factors, including the type of asset, the company's financial health, cash flow, and tax considerations. It can be particularly beneficial for businesses that prefer to preserve capital, need access to the latest equipment, or require flexibility with their asset portfolio. However, it's essential to evaluate the total cost of the lease versus a purchase and understand the implications for financial statements and debt covenants.³

How does lease finance affect a company's financial ratios?

The recognition of lease liabilities and right-of-use assets on the balance sheet under ASC 842 can impact a company's financial ratios, particularly those related to leverage, such as the debt-to-equity ratio and current ratio. While it provides a more accurate representation of a company's obligations, it may initially appear to increase a company's debt, which could influence how lenders and investors perceive its financial risk.²,¹