Leasing 101

Leasing 101: HOW TO NAVIGATE THE LEASING JARGON

We make no representation as to the accuracy or validity of the information in this glossary. We present it for overview purposes only. The reader should seek the advice and guidance of competent experts in using this information for any specific purpose.

Acceptance Certificate: When leased equipment is delivered and installed, the Lessee typically authorizes the Lessor, in writing, to pay for it. The Lessee’s authorization to pay the supplier is indicated on an Equipment Acceptance Certificate form.

Advance Lease Payments: Many leasing transactions call for One (1), Two (2), or more payments in advance. As a rule, when advance payments are required for more than just the first periodic payment, the additional advances will apply to payments due at the end of the lease. If payments are made monthly, for example, one advance will apply to the first month’s payment while any additional advances will be applied to payments due at the end of the lease term. Advance payments are payable at, or prior to, lease inception.

Basis Points: The designation for a fraction of a percentage in interest rate quotes. One percentage point equals 100 basis points.

Benefits of Leasing: Leasing conserves Working Capital. Leasing can provide 100% financing for equipment acquisitions. Leasing keeps existing bank and other lines of credit open. Leasing provides an additional line-of-credit for equipment acquisitions. Leasing helps to overcome budget restrictions and limitations. Leasing helps to maximize cash flow. Leasing may provide tax advantages. Leasing may provide off-balance-sheet financing. Leasing protects against operating obsolete equipment. Leasing hedges against inflation. Leasing is flexible financing that can be matched to specific customer needs.

Book Value: The amount shown for an asset on a balance sheet. Based on historic cost (the amount paid for the asset when it was purchased) and reflecting accumulated depreciation. Book value often differs from market value.

Broker: The entity that arranges transactions between buyers and sellers or between lessees and lessors.

Capital Lease: A lease that meets at least one of the criteria outlined in paragraph 7 of FASB 13 and therefore, must be treated essentially as a loan for book accounting purposes. The four criteria are:

  1. the lease transfers ownership of the property to the lessee by the end of the lease term;
  2. the lease contains a bargain purchase option (i.e., a price which is sufficiently lower than the expected fair value of the property at the date the option becomes exercisable);
  3. the lease term is equal to 75% or more of the estimated economic life of the leased property; and
  4. the present value at the beginning of the lease term of the minimum lease payments equals or exceeds 90% of the fair value of the leased property.

A Capital Lease is treated by the lessee as both the borrowing of funds and the acquisition of an asset to be depreciated: thus the lease is recorded on the lessee’s balance sheet as an asset and corresponding liability lease payable. Periodic lessee expenses consist of interest on the debt and depreciation of the asset.

Capitalized Cost: The cost of equipment to be leased plus the initial direct costs.

Cash Flow: Cash Flow is a critical measure of a businesses’ ability to meet lease obligations. Cash Flow is calculated
by adding the businesses’ ‘Net Income’ to its ‘Depreciation Expense’ for a particular period (i.e. Month, Quarter, Year), and subtracting the ‘Current Portion of Long Term Debt.’ The remainder is the available cash to service new lease obligations.

Common Equipment Lease Types: There are three main types of equipment leases, each with advantages for particular business situations:Operating Lease (Fair Market Value Lease). At the end of the lease period, the customer has the option of returning the equipment or buying it at its fair market value. This type of lease helps the customer avoid obsolescence.

$1 Buy-Out Lease (Conditional Sale Contract). The customer buys the equipment at the end of the lease term for
$1. The payments during the lease term cover the full cost of the equipment, plus interest. This lease is useful for firms that eventually wish to have full ownership.

10% Purchase Upon Termination (Stated Purchase Option). The customer buys the equipment at the end of the lease term for 10% of the initial value. This is useful for customers who expect to keep the equipment, and wish to establish a guaranteed purchase price at the beginning of the process.

Common Vehicle Lease Types: Open-End Lease (TRAC Lease): In an open-end lease, the customer assumes the risk for that market value of the vehicle at the end of the lease. This ‘estimated residual value’ is part of the lease agreement. There are no mileage restrictions or wear-and-tear clauses in an open-end lease. If the vehicle is sold at a price lower than the estimated residual value, the customer may owe all or a portion of the difference – Terminal Rental Adjustments Clause.

Closed-End Lease (Net Lease): In a closed-end lease, the customer makes a specified number of payments and returns the vehicle at the end of the term. There are mileage limits and limits on ‘excess wear and tear’ at the end of the lease, but no ‘estimated residual value’ in the lease agreement. As long as the vehicle is within those limits, the customer is not responsible for the residual value. Leases can be written with higher mileage limits in order to protect against excess mileage charges at the end of the lease.

Corporate Resolution/Certificate of Secretary: A Corporation must attest that the individual executing a Lease Agreement on its behalf is duly authorized to do so. A signatory’s authority is commonly confirmed by the execution of a “Corporate Resolution” or “Certificate of Secretary”. On this form, the Corporate Secretary, or other authorized officer, attests that the signatory is empowered, by name or title, to execute Lease Agreements for the Lessee. The Lessee’s corporate seal is ordinarily required to be affixed to these forms.

Default: A material act that adversely affects a lease agreement between two parties (e.g. not making lease payments or not properly insuring the asset).

Depreciation: A tax deduction representing a reasonable allowance for exhaustion, wear and tear, and obsolescence, that is taken by the owner of the equipment and by which the cost of the equipment is allocated over time. Depreciation decreases the company’s balance sheet assets and is also recorded as an operating expense for each period. Various methods of depreciation are used which alter the number of periods over which the cost is allocated and the amount expensed each period.

Discount Rate: A certain interest rate that is used to bring a series of future cash flows to their present value in order to state them in current or today’s dollars. Use of a discount rate removes the time value of money from future cash flows.

Early Termination: To cancel a lease prior to the end of its initial term.

Economic Life: The remaining period over which a property is expected to be economically usable, with normal repairs and maintenance, for its intended purpose.

Effective Lease Rate: The effective rate to the lessee of cash flows in a lease transaction.

Equipment Lease Schedule: An individual lease contract for a particular transaction that relates to a Master Lease Agreement between the two parties of the lease. This document is used when the general terms and conditions are detailed in the Master Lease Agreement and several transactions are done separately based on the Master Lease Agreement.

Equipment Supplier (Vendor): The seller or vendor of the equipment to be leased.

Estimated Residual Value: The estimated market value of property at the end of the lease term. See residual value below.

Estimated Useful Life: The period during which an asset is expected to be useful in trade or business. Used for purposes of calculating the maximum allowable term of a tax lease. Used for determining whether or not the lease is a Capital Lease. Used to determine the method of depreciation for a capitalized leased asset. May or may not be the same as the life used for income tax purposes.

Fair Market Value: The price for which property can be sold in an “arms length” transaction; that is, between informed unrelated and willing parties, each of which is acting rationally and in its own best interest.

Lease Agreement: The agreement itself is, most often, a pre-printed form that contains the basic terms and conditions, including: the equipment location and usage conditions, insurance requirements, responsibility for taxes and fees, default provisions, late payment provisions, remedies, lessor’s assignment rights, equipment return provisions, indemnity, title to the equipment, and such other or additional provisions as determined by the lessor and by law. The lease Agreement also calls for the exact legal name and address of the lessor and lessee; a specific description of the equipment leased; the name and address of the equipment supplier; a schedule listing the term of the lease, the number and timing of lease payments, the amount of each lease payment, any applicable taxes payable, the number of advance lease payments required; and any additional fees or costs to be paid by the lessee.

Lease Schedule: A schedule to a Master Lease agreement describing the leased equipment, rentals and other terms applicable to the equipment.

Lessee: The party to a lease agreement who is obligated to pay the rentals to the lessor and is entitled to use and possess the leased equipment during the lease term.

Lessor: The party to a lease agreement who has legal or tax title to the equipment (in the case of a true tax lease), grants the lessee the right to use the equipment for the lease term and is entitled to receive the rental payments.

Leverage: The amount of a businesses’ debt compared to its tangible net worth or stockholder’s equity.

Master Lease: A continuing lease arrangement whereby additional equipment can be added from time to time merely by describing that equipment in a new lease schedule executed by the parties. The original lease contract terms and conditions apply to all subsequent schedules. To be contrasted with a lease contract for a single transaction involving a specific unit of equipment, a Master Lease is essentially a line of credit to draw from over time in order to purchase equipment.

Normal Wear and Tear: The average expected wear on a piece of equipment during its lease period under normal usage and conditions.

Off Balance Sheet Financing: A lease that qualifies as an Operating Lease for the lessee’s financial accounting purposes. Such leases are referred to as off-balance sheet financing due to their exclusion from the balance sheet asset and debt presentation, except for that portion of the payments that is due in the current fiscal period. Full disclosure of such transactions is typically made in the auditor’s notes to the financial statements. Periodic payments are recorded as expenses items on the lessee’s income statement.

Operating Lease: A lease which is treated as a true lease (as opposed to a loan) for book accounting purposes. As defined in FASB 13, an operating lease must have all of the following characteristics:

  • the lease transfers ownership of the property to the lessee by the end of the lease term;
  • the lease contains a bargain purchase option (i.e., a price which is sufficiently lower than the expected fair value of the property at the date the option becomes exercisable);
  • the lease term is equal to 75% or more of the estimated economic life of the leased property; and
  • the present value at the beginning of the lease term of the minimum lease payments equals or exceeds 90% of the fair value of the leased property.

Parent Guarantee: A guarantee from a corporation that may own the lessee that is actually legally obligated to a lease. This instrument is used in cases where the lessee does not have sufficient credit to secure financing for a lease on their own.

Purchase Option: Most purchase options are drafted on separate forms. Purchase options forms may state a specific purchase price or the percentage of equipment cost to be paid, the terms and conditions for purchase option exercise, and any other provisions, such as the method employed for determination of “fair market value” (if applicable), established by the lessor.

Residual Value: Most equipment has a remaining or resale value at the end of the original lease term. The remaining value is referred to as the ‘residual value.’

Sale/Leaseback: Businesses can sometimes raise capital by selling owned equipment to lessors and then leasing the same equipment back. When lessors consider sale/leasebacks, an equipment appraisal by a recognized appraiser, at the lessee’s expense, is generally required. Generally, lessor’s will offer the auction value, or less, as the buying price for the equipment to be sold and leased back.

Security Deposits: Similar to advance lease payments, security deposits are paid at, or prior to, lease inception. Security deposits protect the lessor by offsetting losses due to unreasonable wear and tear to returned equipment, the non-return of equipment, or any other costs incurred due to the lessee’s actions or negligence.

Structured Leases: A major leasing benefit is the lessor’s ability to meet specific needs through lease structuring. Common lease structures include:

Step-Lease: Some Step-Leases call for lower payments early in the Lease term and higher payments later on. Businesses acquiring more costly or higher capacity equipment than currently needed, but who will require greater productivity in the future, may find this plan attractive. Rather than installing a smaller unit today, and then having to soon upgrade or replace the equipment, reduced front-end lease payments can permit the acquisition of higher capacity equipment at the outset. Conversely, Step-Down leases can permit a faster write-off of leased equipment that will be obsolete in a short period of time. This structure matches the higher front-end leasing payments to the highest productivity stage of equipment usage.

Skip Payment Lease: This structure permits payment reductions or abatements during seasonal businesses’ slow periods. Seasonal businesses can then match their lease payments to the times of year that a business generates its income.

No-Payment Lease: This lease structure offers a payment moratorium at lease inception. Ordinarily, the nopayment period is limited to two or three months, but may sometimes extend as long as six months. Businesses benefit from no-payment leases when new equipment requires a break-in, operator training, or set-up phase. This way, the lessee is not required to remit lease payments during the equipment’s initial start-up stage. No-Payment leases also help when existing equipment will be replaced shortly, but some leasing or financing payments remain. With a No-Payment period, Lessees can install new equipment earlier while avoiding making payments for both items. Often, installing new equipment while an older unit is still in place permits easier changeover and transfer to newer technology.

Tax Lease: A generic term for a lease in which the lessor takes the risk of ownership (as determined by various IRS pronouncements) and as the owner, is entitled to the benefits of ownership, including tax benefits. Taxes: Most lease agreements require the lessee to pay any applicable taxes or fees related to the leased equipment, including sales or use tax, or personal property tax.

Termination Charge: A fee that is specified in a lease as payment by a lessee to a lessor to compensate the lessor for termination of a lease contract.

Uniform Commercial Code (UCC): The state law that requires a company to file a claim form to designate its ownership of leased equipment.

Useful Life: The period of time during which an asset will have economic value and be usable. The useful life of an asset is sometimes called the economic life of the asset. To qualify as an operating lease, the property must have a remaining useful life of 25 percent of the original estimated useful life of the leased property at the end of the lease term, and at least a life of one year.

Print Friendly