Leverage Leasing - Lease v.

Leverage Leasing - Lease v. Buy Argument

The answer to the question: Does it make more sense to buy or lease?

Jennifer Schiff (2005) in "Buy vs. Lease: What You Need to Know," requires consideration of a number of factors, including, but not limited to cash flow, cost, depreciation, tax ramifications, and company forecasts. During her research efforts, Schiff explored decisions regarding buying and leasing of "two fast-growing small businesses, one that made the buy decision...[;] one that decided to lease" (¶ 1). In addition, Schiff interviewed executives at Dell Financial Services and HP Financial Services for perspectives on buying vs. leasing. In light of contemporary debates relating to the lease vs. buy argument, noted by Schiff and others (Brady & Ingram 2006; Hamill, Sternberg & White 2006,), this paper presents a sampling of relevant information, with the researcher particularly focusing on leveraged leasing.

Two primary points Schiff (2005) asserts from her study effort include:

When a business focuses on cutting-edge technology, buying may make more sense

Schiff 2005, ¶ 2).

When a business's primary concern includes controlling cash flow, and the owner/manager does not have time to invest in equipment related concerns, leasing may prove to be a better option (Schiff 2005, ¶ 2).

In "The lease vs. buy dilemma: which option is best?," Marc Newman (2008), CPA, suggests the following two "rules of thumb" for determining which option proves to be the best choice. 1. Consider that the use of equipment, not its ownership, contributes to operating profits. The leased equipment generates funds for lease payments, a particularly relevant point "when the useful life of the equipment is the same or shorter than the term of the lease" (Newman 2008, ¶ 2). 2. Although not universally true, "buy what appreciates and lease what depreciates," serves as another traditionally solid guide (Newman 2008, ¶ 2).

Leases

Leases may be negotiated while they simultaneously provide for a range of rights applicable to contracting parties. James R. Hamill (University of New Mexico), Joel Sternberg (Clark University), and Craig G. White (University of New Mexico) (2006) define a lease basically as "the purchase of the use of an asset over a specified period of time" (Grenadier, as cited in Hamill, Sternberg & White 2006, p. 43). "These rights provide differing opportunities for flexibility to the lessee [,] and are key to the valuation of the option portion of the contract" (Hamill, Sternberg & White 2006, p. 43).

Buying

Considerations for Businesses Regarding Leasing and Buying Ensuring cash will be available for slower months may prove critical for some seasonal operations in a number of businesses questions (Newman 2008, How Important Is Controlling Cash Flow? section ¶ 2). Newman asserts businesses comparing options of leasing and buying equipment need to consider: (a) the amount of cash the business can afford to disburse up front, either from a credit line or the business's liquid assets; (b) Whether the business will be able to continue pay its operating expenses, and afford to cover unforeseen expenses if/after it expends a lump sum; - the percentage of the business's credit line a purchase would take; (d) the effect/s of depleting the business's capital by, for example, $24,000 at once, or $245 per month for a preset period; (e) Whether or not lease options such as skip-payments c Sharp ould benefit business (Newman ¶ 2).

Operating Lease or Capital Lease

An operating lease basically constitutes a rental agreement stipulating equipment may be returned at the end of the lease, or purchased for a specific price. A capital lease specifies that the leaser may either purchase the equipment, or at the end of the lease term, pay an ostensible amount to own the equipment (Newman 2008, Two Types of Leases section). When leasing appears to be the best option, the individual or business must determine whether an operating lease or a capital lease best fills the need. The following six considerations, reportedly appropriate for determining whether to secure an operating lease or a capital lease, include:

The anticipated life-span of the equipment. "For tax purposes, the IRS considers most equipment (other than passenger vehicles) to have a useful life of seven years" (Newman 2008, Two Types of Leases section). 2.

At the end of the lease term, whether the equipment's residual value of the equipment constitutes consideration of the purchase option. 3. Whether EPA and/or other community guidelines affect the disposal of old equipment (may mandate consideration for purchase consideration). 4. The business's perception regarding equipment's status. 5. The real cost, over time, to lease equipment. These include finance costs; cost of lost liquidity, etc., "compared to the cost of purchasing the equipment, for example, lost interest or lost liquidity" (Newman 2008, Two Types of Leases section). 6. The impact of decision on business's financial statements. Contrary to purchased equipment, according to traditionally acknowledged accounting rules, leased equipment and/or lease debt may not need to be listed on a business's financial statement. (Newman 2008, Two Types of Leases section)

Concept of Leveraged Leasing

Leveraged Leasing, a Powerful Equipment Finance Tool

Numerous corporations utilize the leveraged lease product to finance capital equipment acquisitions. Deborah Brady and Paul Ingram (2006) explain in "A leveraged lease primer" that:

Commercial aircraft, vessels, railcars and manufacturing lines are assets commonly acquired using this vehicle" (¶ 1). With its optimized structure and inherent tax benefits, leveraged leasing constitutes an attractive financing option. Frequently, during the course of an accountant's work in the financing and/or accounting areas, his/her work will encompass leveraged leasing. To critically and effectively examine such transactions, the accountant will need to ensure he/she understands leveraged leasing.

In "Leveraged leasing," Ashook Roy (1990) explains: "A leveraged lease is a long-term lease in which a major part of the purchase price of the to-be-leased asset is financed by a third party" (¶ 1-2). The lessor combines his/her funds with borrowed money to purchase an asset that requires large capital expenditures. After the purchase is completed, the lessor leases the asset to another party (Roy).

Contrary to an ordinary lease where only two parties, the lessee and the lessor, are involved, three parties participate in a leveraged lease: the lessee, the lessor, and the term lender. Roy (1990) further explains that a leveraged lease is basically a long-term lease where a third party finances primary part of the purchase price of the future to-be-leased asset. The lessor uses a combination of its own funds and borrowed money to purchase the asset (requiring large capital outlays), which is later leased to another party.

Three Parties in Leveraged Leasing the three parties in leveraged leasing, Roy (1990) recounts, include the term lender, the lessor, and the lessee. Genearally, the term lender will be a bank, an insurance company, or a superannuation fund. In return for providing the lessor with "a 'non-recourse' basis 60-85% of the purchase price, the term lender receives debt service from the lessor. The following notes additional information regarding leverage leasing:

The "non-recourse" basis is that the term lender has no legal recourse against the lessor in the event of a failure to meet debt repayments (in other words, the term lender can look only to the security). The security is a chattel mortgage over the lease and an assignment of the lease rentals (generally, no charge is taken over the equipment subject to the lease). The term loan may be in foreign currency named loan funds or on fixed/floating rates. In cases where the asset being financed is very costly, it is usual to have a number of lessors and a consortium of lenders. One of the lessors, in such a case, acts as the packager arranging the leveraged lease.

Basic Leveraged Leasing Components at a minimum, a leveraged lease involves a lessee, a lessor, and a long-term creditor. Generally, an organization with an investment grade credit rating defines the lessee, the end user of the equipment; however, a credit guarantee from a more highly rated organization may support a non-investment grade lessee. Traditional lessees include manufacturers, energy producers, railroads, energy, and airlines (Brady & Ingram 2006, Leveraged Leasing Basics section ¶1). In addition, Brady and Ingram (2006) note:

The lessor, commonly referred to as the equity investor or owner, invests an amount much less than the full cost of the equipment. The amount of the equity investment varies by transaction, but many lessors invest around 20% - 35% of equipment cost. Despite this relatively small investment, the lessor is able to depreciate the full equipment cost for tax purposes. Lessors, be they bank-owned leasing companies, independent leasing companies or captive financing companies, usually have large tax bases to fully utilize these benefits.

The remaining 65%-80% of the cost of the equipment is provided by the long-term creditor. The long-term creditor, often referred to as the third party or non-recourse lender, is the provider of the transaction's leverage. Banks, insurance companies, pension funds, or others seeking long-term returns on a money-over-money basis provide the leverage. More than one lender may participate in a given transaction. The lenders loan funds to the lessor but look to the credit of the lessee and the equipment value in the event of default. In other words, the lending is non-recourse as the lessor is not responsible to repay the loan in the event of default. The lender has some protection in that its claim does precede the lessor's claim in the event of default.

The power of the leverage effect and tax benefits lowers the money-over-money rate to the lessee relative to a typical tax lease or straight loan. Since the lessor is able to depreciate all of the equipment with only a relatively small equity investment, this economic benefit can be shared with the lessee in the form of lower rates. A leveraged lease can also be structured to meet the specific needs of the parties involved. Specialized pricing programs can optimize rent and debt schedules to meet particular criteria, such as lowest present value of rent to the lessee, highest book earnings to the lessor or minimum investment duration for the lenders. Early buyout options are popular features and give the lessee the advantage of a definite purchase price for the equipment at a particular point in the lease term. In order to avoid jeopardizing the lessor's tax treatment, the early buyout option cannot be set at a bargain price. (Brady & Ingram 2006, Leveraged Leasing Basics section ¶ 3-4)

Rules for Leverage Leasing for the lessor to comply with the tax requirements of a leveraged lease, while also qualifying to depreciate the leased equipment, the lessor must also possess the risks and rewards that accompany ownership. Brady and Ingram (2006) explain that: "In a true tax lease, the lessor can depreciate all of the leased equipment, not just that portion financed on an equity basis" (Tax Treatment section ¶1). In addition, as the non-recourse debt is treated as a loan between the lender and the equity participant, the lessor can deduct interest paid to the lender (Brady & Ingram 2006, Tax Treatment section ¶1).

In Revenue Ruling 55-540, the Internal Revenue Service (IRS), proffers some directives to determine if a transaction qualifies for true lease status. For federal income tax purposes, when/if a transaction possesses even one of the following characteristics portrayed in the following figure (1), it may not be considered a true lease (Brady & Ingram 2006, Tax Treatment section ¶ 2):

Figure 1:

Even One These Factors Negates Qualification of a True Lease adapted from Brady & Ingram 2006, Tax Treatment section)

In response to the increase in leveraged lease volume during the 1970s, and ensuring requests for advanced rulings to determine whether particular transactions could qualify for true lease status, the IRS issued Revenue Procedure 75-21. This Procedure provides standards to obtain an advance letter ruling from the IRS. Leveraged leases that meet the following standards depicted in the following figure (2) routinely receive a favorable ruling regarding the transaction's true lease classification (Brady & Ingram 2006, Tax Treatment section ¶1):

Figure 2: Standards for Leverages Leases to Receive True Lease Classification adapted from Brady & Ingram 2006, Tax Treatment section)

During 1999, the IRS finalized Code section 467 regulations, which were adopted with (but not exclusively these) the specific allocation of rent, along with section 467 loan structuring techniques routinely used today. The leveraged lease structuring approaches could significantly improve a transaction's economics (Brady & Ingram 2006).

Accounting for Leverage Leasing Financial Accounting Statement (FAS) #13 addresses leveraged lease accounting. The following factors, presented in the following figure (3) must prove true to qualify to use leveraged lease accounting (Brady & Ingram 2006, Accounting Classification section ¶1)

Figure 3: Factors Which Utilization of Leveraged Lease Accounting (Brady & Ingram 2006, Accounting Classification section) leveraged lease possesses a separate accounting classification. FAS #13 notes that the lessor's leveraged lease investment "is recorded on the balance sheet net of the non-recourse debt" (Brady & Ingram 2006, Accounting Classification section ¶ 2).

At some specific points during the lease term, the deferred tax balance may prove to be more than the leveraged lease balance's investment, known as the sinking fund period or disinvestment period. "During the disinvestment period, the lessor has in its possession more cash than it initially invested in the transaction and may then utilize that cash for additional lending or other corporate uses" (Brady & Ingram 2006, Accounting Classification section ¶ 4).

Consequently, the lessor's net investment, its investment less deferred taxes, is utilized for the foundation of income allocation. Leveraged lease earnings, only allocated to times when the lessor's net investment proves to be positive. During the disinvestment period, earnings are not recognized on the income statement, a method of income allocation, deemed as the multiple investment sinking fund (MISF), the method necessary for leveraged leases (Brady & Ingram 2006, Accounting Classification section ¶ 4).

The following figure (4) portrays a summary, reflecting how leveraged lease earnings are derived:

Figure 4: Summary of Ways Leveraged Lease Earnings are Derived

Brady & Ingram 2006, Accounting Classification section ¶ 4)

Leveraged lease pricing programs may conduct these calculations prior to the booking of the lease. Brady and Ingram (2006) explain, however, that earnings patterns of book earnings, calculated on an after tax accounting balance, are usually u-shaped; higher at the lease's starting and final years; lower during middle years. "The impact of deferred taxes is to initially lower the after tax accounting balance. Over time, this effect is reversed as taxes are paid and the deferred tax liability is reduced" (Brady & Ingram 2006, Accounting Classification section 5). Due to the utilization of pre-tax accounting balances, single investor leases traditionally reveal a downward-sloping earnings pattern throughout their life span.

Conclusion

Benefits of Leverage Leasing

In leverage leasing, the equipment and its use, as lenders in this industry understand, generates fast and easy approvals ("

Capital equipment: Lease vs." 2007). It preserves the lessors credit lines, while it also offers distinct tax benefit. As a result, a number of accountants attest that leasing may be in their customers' best interests.