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Oct 04 2021

How Leasing Works: A Simple and Practical Guide for Asset Management

Leasing can be a powerful and cost-effective way to get your business the equipment it needs. By including leasing as a part of your asset management approach, you can reduce costs. Additionally, you can avoid the end of term responsibilities and stay up to date with the latest tech. Yet, if you’re unfamiliar with leasing, it can also be a complex process to wrap your head around. 

This article breaks down what a lease is, the different types of leases available, and what you can use leasing for in your business.

What is a Lease?

Leasing is a major corporate financing strategy used across a wide range of businesses and sectors. 

At its simplest, a lease is a deal made between two parties, the lessee and lessor, over the use of an asset. Instead of buying the asset upfront, the lessee pays a set amount for the right to use it, usually in instalments over the life of the lease agreement. 

By the end of the lease, the lessee has paid the lessor either all or part of the asset’s market value.

A lease is an agreement where the lessor conveys to the lessee, in return for payment or series of payments, the right to use an asset for an agreed period of time.

-The International Account Standards Board

What can be Leased?

Almost any asset that can be purchased can also be leased, from laptops and servers or a vehicle fleet, right up to specialist medical equipment. Without leasing, many businesses, large and small, would find it costly and difficult to procure the equipment they rely upon to operate. 

Lessees and Lessors

There are two parties in a lease agreement: the lessor and the lessee. 

Lessee

The Lessee is the company or person who wants to use the assets.

Your payments allow you to use the equipment for your business according to the terms of the lease agreement, but you are not the legal owner. It is your responsibility to negotiate the clauses within the agreement. You must also take care of the assets while they’re in your possession.

Lessor

The lessor is the company supplying you with the finance for the equipment to be leased.

The lessor maintains ownership of the leased equipment. Their main responsibility is to provide you with the right to use the equipment without any interference. They are also responsible for disposing of the asset in line with ethical and environmental regulations.

Types of Leases

Traditionally there have been two main lease types, finance and operating leases. While the functional distinction remains, they are now treated the same for accounting purposes, under the IFRS 16 reporting guidelines.

What is IFRS 16?

In 2019, a new accounting standard was introduced to create a single model for reporting leases between the International Accounting Standards Board (IASB) and the US’s Financial Accounting Standards Board (FASB). 

IFRS 16 is designed to ensure greater transparency and comparability between businesses across different industries, by eliminating the distinction between operating and finance leases. The most significant impact is that it brings most leases on-balance-sheet, therefore recognising both an asset and a liability. This makes it essential for businesses to keep an accurate, up-to-date record of all their leasing activities.

Short term leases (less than one year) and leases of low value (around US $5,000 for each asset) are exempt from IFRS 16, and will continue to be treated as operating leases, under the previous rules.

Finance lease versus operating lease

Finance Lease

Operating Lease

  • The lessor transfers ownership of the equipment to the lessee at the end of the lease
  • For the lessee, this is like a bank loan and is treated as a depreciating asset with associated contingent liabilities 
  • Lease payments are higher than an operating lease because the lessor does not invest in the equipment’s market value at the end of the lease
  • Running costs are not included so there may be greater administration and price fluctuation
  • There is an option to buy out the equipment at the end of the lease, continue the lease at a minimal rate, or return the equipment (although this option is rarely chosen, as the total will be greater than the purchase price
  • Treated as an asset on the balance sheet, before and after IFRS16
  • Most suitable for long-life equipment, or when ownership at the end of term is desirable
  • The lessor keeps ownership and title of the equipment during and after the lease
  • The lease payment amount reflects the lessor’s investment in the equipment’s market value at the end of the lease and the total lease cost is less than the purchase price of the asset
  • Lease payments are lower than a finance lease
  • All running costs are included within the lease, according to the terms of the agreement
  • Typically, you don’t have the option to buy out the equipment at the end of the lease but can return, extend or replace the asset, depending on the agreement
  • Pre-IFRS16 did not appear on the balance sheet. Post-IFRS 16 appears on the balance sheet unless short-term or low-value exemptions apply. 
  • Most suitable for large assets such as aircraft, vehicles and property, or assets with a high rate of obsolescence such as technology

Conversion to leasing

Conversion to leasing, or ‘sale and lease back’, is another type of leasing arrangement where the owner of an asset sells it for an agreed sum and takes back a lease on it from the new owner. Under this arrangement, the seller of the asset becomes the lessee, and the buyer becomes the lessor.

Before IFRS 16, conversion to leasing was often used in commercial sectors to free up capital which could be used to invest in business activities, pay off debts or buy core assets, while still having use of the asset. 

Since IFRS 16, you must satisfy the accounting rules for the sale of the asset before it goes into the balance sheet, making reporting obligations for this type of arrangement more onerous. However, it’s still possible to manage this complexity. For example, Quadrent uses conversion to leasing contracts where equipment is purchased but still treated as a lease (rather than a sale and leaseback) to achieve a similar result.

Is Leasing Right For Your Business?

The complexities of leasing have led to it being an underutilised strategy for many businesses. But, deciding whether leasing is right for your company can be a complex process in itself. At Quadrent, we have a long history of helping businesses navigate this complexity.

To help you figure out if leasing is the correct choice for your business, we’ve created an ebook with everything you need to navigate the leasing world. The ebook includes a detailed comparison of the benefits of leasing versus buying and more information on your leasing options. Download the ebook to learn more.

Learn About Why You Should Lease