I ate dinner in a Chinese restaurant yesterday and cracked open my fortune cookie. The advice on the little white piece of paper said: “It is a wise man who knows whether it is better to lease or buy.” This is even truer today given that operating leases are capitalized as an asset and liability under the Financial Accounting Standards Board’s Topic 842, and the 2017 Tax Cuts and Jobs Act changes the tax benefits of borrowing in the buy scenario. I contend that it is almost always better to lease assets than to buy them.
This article will analyze the reasons why companies lease and demonstrate how choosing the right lease product and structure can result in improved financial results, most notably earnings per share (EPS), return on assets (ROA), and return on equity (ROE).
The messages of this article are: First, a traditional lease versus buy analysis is the necessary first step in deciding whether you, the lessee, should be the tax owner or not in the financing of the use of a business asset, and it used to be all that you needed to do when operating leases were off-balance sheet. BUT, second, and more importantly now, I suggest a “new” analysis is needed that is a pro forma financial presentation analysis using a present valued ROA calculation to determine what structure is best to enhance the financial presentation of the transaction for your company. The old adage “you are how you are perceived” is the issue. Your investors’ and lenders’ perception is what counts, so choose the structure that improves the financial ratios and measures that are drivers for your business.
Seven Reasons Why Companies Lease
Raise Capital—Leasing is an alternative and valuable funding source for businesses to acquire the use of equipment and real estate assets that has limited impact on their risk profile versus adding more debt. Small and medium sized companies (SMEs) may have limited borrowing capacity as well as limited, if any, access to public debt markets. Many such SMEs lease almost any asset they can from leasing companies to preserve their borrowing lines with banks. Non-investment grade companies have limited borrowing capacity. Any company, even investment grade companies, should be concerned with using their revolving lines of credit as they are not unlimited and typically include covenants, while leases typically do not include covenants.
Leasing has liquidity benefits as it finances 100% of the asset cost on a fixed rate basis with level payments and a term that can nearly match the leased asset’s useful life.
Lower the Cost of Capital—Companies that have negative tax positions such as a net operating loss (NOL) or interest expense deductibility limits can pass on the tax benefits of equipment to lessors in return for lower lease rates than the cost of other borrowing alternatives. Also, rent in a true lease is always tax deductible.
Operating leases are now capitalized on balance sheet at less than 90% of the asset cost and, for assets that hold their values such as transportation and infrastructure assets, the amounts capitalized are significantly lower than the asset cost. Even finance leases (formerly called capital leases) can be creatively structured to capitalize at amounts of 90% or less than the asset cost. When a company has the economic benefits from the use of an asset yet report amounts on balance sheet at less than the asset cost, the capital needed to support the asset is less, and thus the cost of capital is less than borrowing to buy.
Manage Taxes—Can the company utilize 100% “bonus” modified accelerated cost recovery system (MACRS) depreciation deductions associated with equipment immediately (having no NOL) or does it have an interest deductibility limitation? Thanks to the structuring options available for leases, either the lessor or lessee can be the tax owner and take the depreciation tax benefits associated with the asset and avoid non-deductible interest expense. If the lessor is the tax owner, the benefits will be passed on to the lessee in the form of a lower lease rate. Choosing the right lease structure will result in the lowest after-tax financing cost to the lessee company.
Manage Financial Presentation—Operating leases are no longer off-balance sheet under the new accounting rules, but the amounts capitalized on balance sheet are less than the cost of the asset. As a result, they are partially off-balance sheet. Both finance leases and operating leases can be structured to capitalize 90% or less of the asset cost on balance sheet, thus presenting better ROA and ROE measures. ROA is a factor in many employee compensation plans and a measure that analysts use to compare companies’ performance. For financial reporting purposes, operating leases present a level cost (rent expense) versus a front-loaded cost pattern for finance leases and borrowing to buy (in those cases, the reported cost is straight-line depreciation and front-loaded interest expense). This favorable expense pattern for operating leases is a deferral of costs and results in better ROA and ROE as well as better EPS results.
If you continue the policy of leasing assets, this deferral of costs creates a permanent EPS and ROA/ROE benefit. Also, the longer the average life of the operating lease, the better the financial presentation benefit. Operating leases also have the benefit of the presentation of the capitalized lease obligation as an “other operating” liability (instead of debt), which avoids issues with debt covenants that limit debt. Because they are not reported as debt, operating leases have less of an impact on debt and leverage ratios.
As a word of caution, although U.S. generally accepted accounting principles (GAAP) assert the operating lease liability is not debt, some covenants recharacterize synthetic leases as debt and true leases if classified as finance leases as not debt. Some covenants define debt as the reported total liabilities on the balance sheet. Also some covenants limit operating lease volume. Lessees should review their covenants and seek to amend if necessary.
Furthermore, despite leases being capitalized, rating agencies, like Moody’s, may continue to use some judgment in treating leases in their capitalization methodologies. Companies concerned with earnings before interest, taxes, depreciation, and amortization (EBITDA) show better results with borrowing to buy and with finance leases as the depreciation and interest costs are excluded from the EBITDA calculation. However, in the case of EBITDA driven companies, the finance lease option with lower capitalized asset and liability amounts will show better results for other financial ratios and measures than borrowing to buy.
Manage Assets—Companies that have a temporary need for assets will lease so they can return the asset when the need is fulfilled. An example would be leasing construction equipment for a project or rail cars for large delivery contracts or periods of heavier use need. Companies also pass on the risk of obsolescence through operating leases as the lessor assumes the residual risk when the asset is returned such as with computers and high-tech equipment (e.g., medical computing, servers, networks, etc.). Some companies need to have new or like-new assets, such as company cars for sales staff. In these cases, companies will want operating leases. The flexibility to renew or buy or return the asset is also a benefit.
For Convenience and Service—Leasing is often a point-of-sale finance option with a simple documentation process and quick turnaround of the funding raise. A lease can include services such as repairs, maintenance, providing a driver/operator, and providing back-up assets
Manage Regulatory Issues—Regulated industries, such as insurance, broker/dealers, utilities, and banks lease for capital reasons.
The Lease or Buy Decision Process
The traditional lease-versus-buy analysis is a present value after-tax cash flow financing cost analysis to determine whether a true lease or borrowing to buy is the lowest after-tax financing choice. It should be the first step that a lessee takes in the lease or buy decision process. The next step is to determine which structure will work best to achieve the lessee’s financial objectives. The choices are: (1) borrow to buy, (2) lease under an operating lease, or (3) lease under a finance lease (formerly known as a capital lease).
Leases can be structured as true leases, or financings, for tax purposes, while for accounting purposes, leases can be structured as operating leases or finance leases. Operating leases can be structured with fixed price purchase options as long as they are not bargain purchase options. I recommend that lessees ask for non-bargain fixed price purchase options in all operating leases to ensure they know the maximum cost of the transaction and have flexibility to buy out the lease and retain long term control of the asset. The last step is to compare options by running out proforma financial results, which is covered in more detail below.
Borrowing to buy is the worst choice from a financial reporting perspective, for three reasons:
(1) Leases, whether finance or operating, will always result in a lower capitalized value, yet they provide 100% financing, so ROA and ROE measures will be better than borrowing to buy.
(2) For operating leases only, the cost pattern is level versus front-ended for finance leases and borrowing to buy so EPS, ROA, and ROE results will be better than borrowing to buy.
(3) For operating leases only, the liability is not debt, so debt covenants and leverage ratios and measures are impacted more favorably.
Considering EBITDA, the finance lease is better than the operating lease as the interest and depreciation are “below the line.” Again, the finance lease is better than borrowing to buy because the balance sheet asset amount is lower, as is the liability.
Other Technical Details to Consider
I have to apologize in advance for this section of the article as it is very technical, but the decision process is inherently involved—I can’t get around that, so here goes.
If the lessee can deduct the 100% “Bonus” MACRS depreciation deduction and has no interest deduction limit issue, and if they are measured predominantly by EBITDA, then the lessee may want a finance lease (currently called a capital lease) giving tax benefits to the lessee, but with a present value (PV) of payments of less than 100% of the cost of the leased asset. If EBITDA is not the main driver, it may make sense to structure the lease as a synthetic lease (operating lease) with the lowest capitalized amount while giving tax benefits to the lessee.
For EBITDA driven companies, the lease should be structured with minimum payments that PV, for lease classification purposes, to 90% of the asset’s cost. This is best achieved by structuring a synthetic lease with a higher residual value guarantee (RVG) than in a “normal” synthetic that is structured as an operating lease (89.9% PV).
Note—the liability from a finance lease is classified as debt, so there may be issues with debt covenants. The reason leases with RVGs are best is the RVG is not considered a capitalizable payment as it is a variable payment (unknown). The only portion that would be capitalized is the amount, if any, they expect to pay under the RVG (usually zero at commencement, but that could change over time if the expected residual value declines).
If the lessee has tax issues like an NOL or interest deduction limitation, it should perform a lease versus buy analysis to determine if a true lease or non-tax lease (financing for tax purposes) is best.
If a financing for tax purposes is best, for ALL (EBITDA or not) companies, the lease should be structured with minimum payments that PV to 90% or less as that is the amount that will be capitalized. This is best achieved by structuring a synthetic lease. For EBITDA companies structure the synthetic leases with a higher RVG than in a “normal” synthetic so that it is classified as a finance lease. If “ROA” focused companies, the synthetic lease should be structured to be an operating lease with a PV of 89.9% or less than the cost of the asset.
If a true “tax” lease is the best then look at whether EBITDA is the driver. If EBITDA is the driver, the lease can be structured as a true lease with a 90% PV which could be a terminal rental adjustment clause (TRAC) lease—only available for vehicles and trailers) with a 90% PV. If not an EBITDA lessee, the lease should be a true lease that is also an operating lease (less than 90% PV). If the asset qualifies for TRAC lease provisions under the Internal Revenue Service rules, then a split-TRAC is best as it is an accounting operating lease. If the asset is not a vehicle or trailer then a fair market value (FMV) lease is best. True leases can have RVGs, but they cannot be first loss RVGs (the lessee guarantees a portion of the residual that is less than the expected value of the asset at expiry,). The RVG could allow the lessor to include a higher residual in its pricing and should be allowed by the IRS. Since the RVG is included in the lease classification test it could allow the lease to be classified as a finance lease. The good news is the RVG is not capitalized as it is a variable payment since it’s out of the money.
Focus for CFOs
When the financial numbers are analyzed, the best way to compare the results is to use a present value weighted average return approach (PVROA and PVROE). The PV weighted average approach is necessary when the financial accounting reported results have a pattern that is not level (meaning ROA/ROE varies in each period) as is the case for both borrowing to buy and leasing, be it operating or finance leases. Shareholders are concerned about ROE and EPS, and they have a time value preference as earnings today are worth more than earnings in the future. The suggested discount rate to PV results is the company’s targeted ROE rate. The PV weighted average ROA and ROE are calculated by dividing the PV of the assets or equity and dividing the result into the PV of the after-tax earnings.
If quoted lease rates are higher than borrowing rates from lenders, introduce your lessors to your funding sources. For finance leases only, your funding sources can finance the lease by discounting rents for the lessor. The discounting of rents is not a taxable event for a finance lease. The lessor will reflect the savings in the form of a lower lease rate to you. This idea does not work for true leases as the discounting is considered a sale for tax purposes and triggers a tax liability for the lessor.
Creative lease structuring can be used to improve financial presentation without compromising the cost of financing. A lessee can enjoy the use benefit of an asset via a lease as effectively as debt financed ownership.
See the example below of a $30,000 company car comparing a financed purchase with two types of operating leases—a split-TRAC lease and a synthetic lease (both common fleet lease structures). The results demonstrate that the PV weighted average ROA is three times better under the two lease alternatives versus borrowing to buy. Although not presented, the EPS naturally will also be significantly better than borrowing to buy as well.
As a result, a wise person should:
- Lease instead of borrowing to buy;
- Do a true lease versus finance lease PV after tax cost analysis;
- Get multiple quotes from lessors;
- Choose a lease type that provides the lowest after-tax financing cost and the longest average life;
- For large ticket assets introduce your lenders to work with the lessor as they may discount the payments in a finance lease to lower the lease’s financing rate;
- Seek quotes in which the amount capitalized under the lease is as low as possible;
- Ask for a fixed-price, non-bargain purchase option during the term or at lease expiration;
- Consider how investors view your company and which ratios and measures are most important;
- Run the financial numbers on each option using a present value ROA/ROE and EPS analysis; and
- Choose the right lease structure.
In Hamlet, Polonius said, “neither a borrower nor a lender be,” but I say leasing is great, oh baby!
Example of a vehicle financing
Conclusions and Observations:
- The Buy Case creates a larger reported asset of $32,100 versus the Lease Options of $19,302 from the TRAC lease and 19,634 from the synthetic lease.
- The Buy Case creates a front-loaded cost pattern versus the Lease Cases where the cost pattern is level as they are operating leases.
- The ROA in the Buy Case is lower due to the combination of 100% of the asset cost as an asset and the front loaded cost pattern
- The Lease Cases result in a higher ROA as there is a lower asset amount coupled with a level cost pattern.
- When viewed on a PV basis, the ROA in the lease cases is three times better than the Buy Case.
- Shareholders have a time value preference for earnings and returns—the return on shareholder equity and EPS will show a similar relationship.
- The P&L/EPS benefits are permanent as long as an entity continues to lease as new transactions replace expiring transactions.
- The ROA benefits are permanent as the lease assets are always to least 90% of the “Buy Case” and much lower with assets that hold their value.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
This article has been updated to clarify the treatment of residual value guarantees in true leases.
Bill Bosco is the principal of Leasing 101, a lease consulting company. Bill has over 45 years’ experience in the leasing industry. His areas of expertise are accounting, tax, financial analysis, structuring, pricing and training. He has been on the EFLA accounting committee since 1988 and was chairman for 10 years. He is a frequent author and speaker on leasing topics. He was been selected to be a member of the FASB/IASB Lease Project working group. He can be reached at email@example.com, or 914-522-3233. The author thanks Ted Jenkins, Tom Doughty, Rod Hurd and Rita Garwood for their contributions.