Access the essential membership for Modern Managers
In making purchasing decisions for your budget, you may want to explore the benefits of leasing compared to purchasing equipment outright. This document gives you an overview of how leasing works and the two different types of leases: finance leases and operating leases.
How Does Leasing Work?
A lease is a way of acquiring the benefits of an asset for a set period of time without actually buying it. If your organization is leasing an asset, you (i.e. the lessee) make a rental payment to the organization from which you are leasing (i.e. the lessor) over the period of the lease.
What is the Benefit of Leasing an Asset?
With a leasing arrangement, you are not buying the asset outright. Therefore, you will not need to find the cash to pay for the asset all at once.
Are There Different Types of Leases?
There are two types of lease:
- finance lease
- operating lease
With a finance lease, substantially all the risk and rewards of ownership are transferred from the lessor to you, the lessee. As you effectively own the asset, you should capitalize the asset in your balance sheet, record it as a capital cost and work out the related depreciation charge. There is some complexity in doing this, though. The lease payments are made up of capital and revenue items because of the charge that the lessor has added on top of the value of the asset. These capital and revenue items must be separated and recorded differently.
Although the basic rules of capitalization and depreciation are covered in ‘What Effect Does Capitalisation Have?’ and ‘How To Calculate Depreciation’, there are special accounting rules for finance lease assets. You should consult your finance department if you want to work out what value to record as a capital cost and what depreciation will be charged.
Under an operating lease, the asset still belongs to the lessor, and you, as the lessee, do not take on the risks or rewards of ownership. At the end of the lease, you must give the assets back to the lessor. As a result, the charge for the asset being leased should be recorded as a revenue cost.
How Do You Decide if Leasing is a Good Idea?
In the long run, leasing will cost you more than the original price of the asset. This is because the lessor will charge, over the duration of the lease, more than the value of the asset. This is how the lessor makes its money.
You have various pieces of information that will allow you to identify if taking out a lease is better than buying the asset outright. This hinges on the fact that if you are buying the asset you will likely have to take a loan in order to have the funds to make the purchase. You will be charged interest on this loan. If the lessor charges are less than the loan interest, then opting for the lease would make sense.
What Information Do You Need?
In order to make a leasing decision, you will need the following pieces of information:
- cost of the asset
- expected useful economic life of the asset
- anticipated residual value of the asset
- leasing charge
From this, you can work out the lease's APR (annual percentage rate) and compare it to the APR of a loan. As this calculation can be a little tricky for non-accountants, it is best to contact your finance department and ask them to calculate the APR for you.
