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Balancing the Leasing Equation

How do I decide on products and features?

Equipment leasing shouldn’t happen in a vacuum.
Key Takeaways
  • The finance officer should match leasing products and features with his or her company’s unique ever-changing needs and needs to answer two basic questions: How long will we need the equipment? Which do we need more—the tax break or the cash flow?

  • For equipment a company intends to operate over most of its useful life, or which it wants to own at the end of the lease term, a capital lease may be the way to go. For tax and reporting purposes, a capital lease looks like owned equipment—it appears as an asset and a liability on a company’s balance sheet.

  • An operating lease essentially is an equipment rental. It gives the company options during and at the end OF the lease term to purchase, return, or continue renting the equipment. The lessee’s payments are treated as an operating expense, so they reduce taxable income on the income statement.

CFO

It’s not just about getting the best price. A CFO needs to look at the whole picture, balancing financial, operating, accounting, reporting, and even strategy considerations. Then, he or she can decide what leasing product to employ and which features to put into the lease agreement. Part of the finance officer’s job should be to match leasing products and features with his or her company’s unique needs, which themselves will be changing over time. To start, the finance officer needs to be able to answer two basic questions:

• How long will we need the equipment?
• Which do we need more—the tax break or the cash flow?
 
Essentially, a CFO is weighing the advantages of two financial factors against each other: Tax benefits(minimizing taxable income, maximizing credits and deductions), and operating expenses (keeping costs down, managing cash flow and operating income). 
 
For equipment a company intends to operate over most of its useful life, or which it wants to own at the end of the lease term, a capital lease may be the way to go. For tax and reporting purposes, a capital lease looks like owned equipment—it appears as an asset and a liability on a company’s balance sheet. The lessee can take the depreciation on the equipment and reduce its tax liabilities over the term of the lease. 
 
An operating lease, on the other hand, essentially is an equipment rental. It gives the company options during and at the end OF the lease term to purchase, return, or continue renting the equipment. The lessee’s payments are treated as an operating expense, so they reduce taxable income on the income statement. 
 
But that’s not all the CFO needs to be thinking about. Different leasing products will meet different needs, notes Jim Schatz, a Vice President and Relationship Manager with GE Capital Transportation Finance. Before getting down to terms, he says, many CFOs will already have done their homework on the different funding options: “They know whether it’s going to be a TRAC lease, an FMV lease, the walk-away lease, or a loan.” Schatz’s colleague at GE Capital, Tom Moosey, throws in another option—the rebate lease.
 
For the record, “FMV” stands for “Fair Market Value,” which is what a company may pay to acquire the equipment at the end of an operating lease. A walk-away lease is what it sounds like—you walk away from the deal when it expires, returning the equipment to the lessor. 
 
TRAC leases (a Terminal Residual Adjustment Clause) and GE Capital’s rebate leases are specific to certain types of equipment, such as cars and tractor-trailers. A TRAC lease is structured like a regular lease, while the rebate lease provides a rebate on equipment that is returned with lower usage than planned. “For instance,” explains Moosey, “with our tractors and trailers, customers can earnrebates back if they drive fewer miles than we allot them in the lease. In construction, we also have rebates where, for example, if they don’t use the bucket loader for the agreedupon   number of hours, we’ll give them back a rebate.”
 
“Who is going to take the depreciation is an interesting discussion,” says Jim Jones, CFO and COO of the food services equipment supplier Edward Don. “Sometimes, in negotiating with the lessor, we will give them the depreciation and in exchange we will see a bit lower monthly payment. But then, we went through a recession and everybody had NOLs (net operating losses). If you’re not a tax payer, you can’t use the depreciation. So, it depends on where we are, tax-wise.”
 
The state of the economy can influence a company’s leasing calculus at other times, as well. For example, following the recession, the U.S. Congress raised the limits on Section 179 operating expense deductions to try to boost incentives for business investment. It also passed a program called bonus depreciation, which allowed a company to take all the depreciation in the first year of an equipment purchase (instead of spacing it out over time). While bonus depreciation was limited to new equipment, it did allow a company to take the depreciation even if it had a net operating loss.
 
Tax planning doesn’t have to be an all-or-nothing type of decision, either. Bill Wettstein, CFO of the over-the-road trucking firm Nussbaum Transportation Services, explains how tax strategy figured into Nussbaum’s plans to add rigs to its fleet: “With the bonus depreciation, I was able to get enough depreciation for our tax planning on just a portion of our purchases.” Once they had maxed out the tax benefits, he says, “we would switch and do a tax lease because we get the lower interest rate when the lessor gets the depreciation.”
 
Finally, a lease can also contain an early buyout option(EBO), where the lessee makes a balloon payment to take on ownership before the end of the negotiated lease term. Timing and market conditions will be key considerations when deciding whether to exercise an EBO. 
 
CFOs need to do their homework first, says GE Capital’s Schatz, so that, when they come to the table, “they will know what they are looking for, whether they need depreciation, or if they need it off-balance-sheet, or if they want a longer term to help their cash flow.”
 
Of course, as with any deal that affects income reporting and tax obligations, you’ll need to go through all the options and implications with your tax advisor before making the decision. But, regardless of how any individual lease is structured, it will always be important to keep it in the context of the company’s overall goals formanaging expenses, taxes, depreciation, and the business.

 

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