Equipment leases usually provide an alternative way for businesses that don’t have enough money to purchase necessary equipment. Businesses lease various equipment ranging from airplanes to vehicles to kitchen equipment. Also, there are many ways in which a business lease equipment. These ways of leasing equipment, or types of equipment leases, are the focus of our article.
In a lease, a contract takes place between the owner of the asset and the user of the asset. Under this contract, the owner of the asset gives the user of the asset the right to use his asset. This right is provided for a specific period of time. In exchange for using the asset of the owner, the user regularly pays him a fixed amount of money. Both the parties decide on this amount of money at the time of leasing after negotiating. The user pays this amount either monthly, quarterly, annually, or as per the lease agreement.
Types of Equipment Leases
An operating lease, one of the major types of equipment leases, is a lease agreement in which the owner allows the user to use an asset for a time period that is shorter than the life of the asset. These leases are usually for a time lesser than one year. Examples of operating leases are tourists renting a car, lease contracts for hotel rooms, office equipment, vehicles, etc. The owner gives this right to the user for an agreed period of time in exchange for fixed, regular payments. The ownership of the asset under this type of lease remains with the owner of the asset. Hence, the ownership does not pass to the user under operating leases. The user only gets the right to use the asset during the lease period. Also, operating leases are cancellable at the option of the user of the asset.
The lessee treats his payments under the lease as operating expenses. Also, assets gotten under operating leases are not recorded on the balance sheet as an asset. Similarly, the lessee doesn’t treat operating leases as a liability in the balance sheet. This means that an operating lease is not a debt. The user of the asset also does not record depreciation for the assets he gets to use.
Capital leases are long-term in nature and are very popular with high-value equipment such as aircraft, ships, machinery, plant, etc. In a capital lease, the ownership of the asset passes to the user of the asset, i.e., the lessee. This means that the lessee, after the lease period, becomes the owner of the asset. Also, the lessee treats the lease as a loan. And so, the present value of all future payments, which the lessee has to make, are included under liabilities as a loan. Also, the lease rentals to the lessor (owner of the asset) appear in the income statement as expenses. The market value of the asset acquired under the lease is recorded in the balance sheet under the asset column.
A leaseback is also one of the types of equipment lease. It is an agreement in which the seller of the asset leases it back from the buyer of the asset. Hence, under this type of lease, the seller becomes the lessee, and the buyer becomes the lessor. Most often, companies enter into leaseback agreements when they need the cash invested in a fixed asset, but the asset is still needed for the company to operate.
Let’s understand leaseback with the help of an example. Suppose John started a new business of manufacturing shoes. He manages to get a capital of $5,00,000 from his bank. Out of the $5,00,000 he received, he had to purchase a plant and 4 big machines to start the business. So, he ended up spending $4,90,000 on these fixed assets. Now, he needs another $50,000 to purchase fabric as raw material for manufacturing shows and another $10,000 for electricity and several other variable costs. John has already reached the maximum limit of the credit he can get from his bank. He has also put all his savings into the business.
So, where does he get the additional $60,000? A leaseback deal can provide him with the solution. He sells one of the machinery which he had purchased for $ 1,20,000 to a firm and then takes the same machinery on lease from the firm for an annual rent of $15,000 per annum for 10 years. This way, John managed to get an additional capital of $1,20,000 which he can use for all the operating expenses he needs to incur. This lease will also provide John with tax benefits in the form of deductions of the lease payments which he will make.
TRAC lease stands for Terminal Rental Adjustment Clause. In this type of lease agreement, a layer of flexibility is provided to the lessee. But before we break down what a TRAC lease agreement looks like, let’s understand the concept of residual value in lease agreements, which is at the heart of a TRAC lease agreement.
When a lessor gives equipment on lease, he considers its residual value. The residual value of an asset is the amount that the lessor will get at the end of the lease by selling or disposing of the asset. So, at the end of the lease period, if the lessee decides to purchase the equipment, he will pay the residual value of the asset to the lessor. Typically, the higher the residual value of the asset, the lower the rental payments charged to the lessee.
This way, the TRAC lease provides the flexibility of negotiating the residual value and the monthly payments. If the lessee prefers to pay a large residual amount and lower annual rental payments, he can do that. Or, if the lessee prefers to give higher annual rental payments and lower residual value, he can do that also.
If the lessee does not want to purchase the equipment, the lessor can also sell the asset to a third party. In this case, if the lessor manages to get a higher residual value than the lessor and the lessee had decided, the lessor will return the surplus amount to the lessee. On the other hand, if the asset sells for an amount lower than its residual value, the lessee will reimburse the lessor for the loss.