Leasing

What Is Leasing?

Leasing is a contractual arrangement within the realm of corporate finance where one party, the lessor, grants the right to use an asset to another party, the lessee, for a specified period in exchange for periodic payments. Rather than purchasing an asset outright, businesses or individuals can acquire access to equipment, property, or vehicles through a lease, effectively preserving their cash flow. This financial arrangement allows for the use of an asset without the upfront cost and ownership responsibilities, providing flexibility for lessees while offering lessors a steady stream of income. The nature of a leasing agreement can vary significantly, impacting how the asset and related liability are recorded on a company's financial statements, a key aspect of financial accounting.

History and Origin

The practice of leasing has ancient roots, with evidence suggesting its use in civilizations such as the Sumerians, who leased agricultural tools and water rights. In modern finance, the formalization of equipment leasing began to take shape more prominently in the mid-20th century. A significant development in the United States was the formation of the Equipment Leasing and Finance Association (ELFA) in 1961, initially known as the Association of Equipment Lessors. This organization played a crucial role in the growth and professionalization of the equipment finance sector, advocating for the industry and providing resources for its members.¹³,¹² Over time, leasing evolved from simple rental agreements to complex financial instruments, driven by the desire for tax advantages, flexible financing, and off-balance sheet treatment of assets, which was a common practice prior to recent accounting standard changes.¹¹

Key Takeaways

• Leasing provides access to an asset for a period without requiring outright purchase, preserving capital.
• It involves a contractual agreement between a lessor (owner) and a lessee (user) for periodic payments.
• Leasing can offer financial flexibility, potential tax benefits, and updated equipment access.
• Modern accounting standards now require most leases to be recognized on the balance sheet, reflecting associated assets and liabilities.
• The terms of a lease agreement, such as lease term, payments, and implicit interest rates, dictate its classification and financial impact.

Formula and Calculation

The calculation of lease payments often involves determining the present value of a series of future payments, discounted at a specific interest rate. For a simple lease, the periodic payment can be derived using the present value of an annuity formula, where the total cost of the asset less any residual value is financed over the lease term.

The present value of lease payments (PVA) can be calculated as:

Where:

• (PVA) = Present Value of Annuity (the lease liability or financed amount)
• (PMT) = Periodic Lease Payment
• (r) = Discount Rate (e.g., the implicit interest rate in the lease or the lessee's incremental borrowing rate)
• (n) = Number of Periods (total lease payments over the lease term)

Rearranging this formula to solve for the periodic payment (PMT) when the PVA, rate, and number of periods are known:

This formula helps lessors structure payment schedules and lessees understand the true cost of the lease.

Interpreting the Leasing

Interpreting a leasing arrangement goes beyond simply understanding the periodic payments; it involves analyzing its impact on a company's financial health. For lessees, leasing can allow for the use of essential equipment or property without a significant upfront capital expenditure. This can free up capital for other investments or operational needs. From an income statement perspective, lease payments are recorded as an expense, impacting profitability. On the balance sheet, under current accounting standards (like ASC 842 in the US and IFRS 16 internationally), most leases result in the recognition of a "right-of-use" (ROU) asset and a corresponding lease liability. This provides a more transparent view of a company's financial obligations and assets, making it easier for stakeholders to assess a company's true financial position.

Hypothetical Example

Consider "Tech Innovations Inc.," a small startup needing high-end servers for its operations. Instead of spending $100,000 to purchase the servers (a capital expenditure), they opt for a three-year operating lease. The lessor requires monthly payments of $3,000.

Here's how it plays out:

1. Agreement: Tech Innovations Inc. enters a lease agreement for three years at $3,000 per month.
2. Usage: They immediately gain access to and use of the servers without owning them.
3. Accounting: Under modern accounting standards, Tech Innovations Inc. recognizes a "right-of-use" asset and a corresponding lease liability on its balance sheet for the present value of the future lease payments. The initial ROU asset and lease liability might be, for example, around $98,000, depending on the discount rate used.
4. Expense Recognition: Each month, they record a $3,000 lease expense on their income statement. The ROU asset will also be systematically reduced over the lease term through a process similar to depreciation, reflecting the consumption of the asset's economic benefits.

This arrangement allows Tech Innovations Inc. to conserve cash, avoid the burden of ownership, and potentially upgrade to newer technology at the end of the three-year term.

Practical Applications

Leasing is a pervasive financial tool across various sectors, enabling businesses to acquire necessary assets without the substantial upfront investment of outright purchase. In the United States, the equipment finance sector alone facilitates over a trillion dollars in equipment acquisitions annually, underpinning a wide array of industries from manufacturing and construction to transportation and healthcare.¹⁰,⁹

• Equipment Acquisition: Businesses frequently lease machinery, vehicles, and technology, allowing them to conserve working capital and adapt to technological advancements without significant ownership risks. This is particularly prevalent in industries requiring specialized or rapidly evolving equipment.
• Real Estate: Companies often lease office space, retail locations, and industrial facilities instead of purchasing them, providing flexibility to expand or contract operations based on market conditions.
• Fleet Management: Commercial fleets, such as delivery trucks or company cars, are commonly leased, which simplifies maintenance, disposal, and allows for predictable monthly expenses.
• Technology Upgrades: Many businesses lease computer systems, software, and other IT infrastructure, enabling them to regularly update their technology and maintain competitive advantages without large capital outlays.
• Balance Sheet Management: For some companies, leasing can influence financial ratios like return on assets (ROA) by impacting the reported asset base, although recent accounting changes have significantly altered this aspect.

The Equipment Leasing and Finance Association (ELFA) provides extensive data highlighting the crucial role of equipment finance in the U.S. economy, detailing market size and trends for various types of equipment.⁸,⁷,⁶ This indicates the broad reliance of businesses on leasing as a strategic financing option.

Limitations and Criticisms

While offering significant benefits, leasing also comes with limitations and has faced criticisms, particularly concerning its accounting treatment and long-term costs. A major critique historically revolved around the "off-balance sheet" financing aspect of operating leases, where significant obligations were not fully reflected on a company's balance sheet. This lack of transparency prompted the Financial Accounting Standards Board (FASB) to issue new standards, specifically ASC 842 in the U.S., which became effective for public companies in 2019 and private companies thereafter. These new standards require lessees to recognize nearly all leases on the balance sheet as "right-of-use" assets and corresponding lease liabilities, regardless of classification as operating or finance leases.⁵,⁴,³

This change has had a profound impact, significantly increasing reported assets and liabilities for many companies, which can affect key financial metrics such as the debt-to-equity ratio.² For instance, some industries, including airlines, retail, and transportation, have seen their total assets and liabilities rise substantially following the adoption of IFRS 16 (the international equivalent of ASC 842).¹

Other limitations include:

• Total Cost: Over the long term, the total cost of leasing an asset can sometimes exceed the cost of purchasing it outright, especially when considering the opportunity to fully amortize the asset.
• Lack of Ownership: Lessees do not build equity in the asset, and they do not own the asset at the end of the lease term unless there is a purchase option. This can be a disadvantage for assets with a long useful life or those that appreciate in value.
• Restrictive Covenants: Lease agreements often contain clauses that restrict how the asset can be used, modified, or maintained, which can limit operational flexibility.
• Obligation to Pay: Even if the leased asset becomes obsolete or is no longer needed, the lessee is typically still obligated to make all remaining lease payments.

Leasing vs. Buying

The decision between leasing and buying an asset is a fundamental financial choice for businesses and individuals, each with distinct implications.

Leasing offers flexibility and typically lower initial cash outflows, making it attractive for assets that depreciate quickly or require frequent upgrades. Buying, conversely, provides full ownership, the potential for equity building, and complete control over the asset, which may be preferable for assets with long useful lives or those expected to appreciate.

FAQs

What types of assets can be leased?

Almost any tangible asset can be leased, including real estate (like office buildings), vehicles (cars, trucks, airplanes), and equipment (machinery, computers, medical devices). The suitability often depends on the asset's useful life and the business's specific needs.

Are there different types of leases?

Yes, the two primary types are operating leases and finance leases (formerly known as capital leases). The classification primarily depends on whether the lease effectively transfers the risks and rewards of ownership to the lessee. Under modern financial accounting standards, both generally result in a "right-of-use" asset and a lease liability on the balance sheet, though their impact on the income statement can differ.

How do accounting changes affect leasing decisions?

Recent accounting changes, such as ASC 842 and IFRS 16, require companies to recognize nearly all lease obligations on their balance sheet. This increased transparency means that "off-balance sheet" financing, once a driver for operating leases, is largely eliminated. While the financial impact is more visible, leasing remains a viable option for managing cash flow, upgrading technology, and accessing assets without large upfront costs.

What happens at the end of a lease term?

At the end of a lease term, several options are typically available, depending on the lease agreement. These can include returning the asset to the lessor, renewing the lease for another term, or purchasing the asset at a predetermined price or fair market value. Some leases may also require the lessee to facilitate the sale of the asset.

Can a leased asset be used as collateral?

Generally, a leased asset cannot be used as collateral by the lessee because the lessor retains ownership of the asset. The lessor is the party who would typically use the asset as collateral if they finance its purchase.