What Is a Leveraged Lease?
Understanding Leveraged Leases
Leveraged leases are most often used in the renting of assets planned for short-term use. Assets like cars, trucks, construction vehicles and business equipment are typically all available through the option of leveraged leasing. Leasing in general means a company or individual will be renting an asset.
Leasing any type of asset gives an entity the right to use the asset for a short-term. In general, the entity is only renting the asset although many leveraged leases offer a buyout option at the end of the lease term.
The leveraged aspect of a leveraged lease involves borrowing funds to pay for the high cost of the asset’s value. A leveraged lease is usually used when an entity does not have the funds to buy the asset outright nor do they necessarily want to keep the asset for a long-term. A leveraged lease allows a lessee to obtain a loan for the leased asset’s value during the lease term and repay the loan over the life of the lease. The amount needed for the loan can be lower than buying the asset outright because the lessee is only paying for a specified value associated with the length of time on the lease.
Accounting standards require a business to differentiate and account for leased assets differently depending on whether the lease is an operating lease or leveraged/capital lease.
Leverage Lease Structure
Leverage leases can be more complex than a basic operating lease because leverage is involved. The structure of the leveraged lease terms will depend on the lessor and their financing relationships. The lessor may also be the financing institution who provides the loan in which case they approve the loan for the borrower.
The lessor may also work with a third party lender. In this case, the third-party lender provides the borrowed funds to the lessor on your behalf allowing you to take possession of the asset as soon as a loan is approved. In some cases, a lessor may put up some funds combined with borrowed funds from a third party which can help to improve the overall terms of the lease.
Once a leveraged lease is approved and agreed on, the borrower takes possession of the asset and is responsible for making regularly scheduled payments toward the loan balance. The asset’s title is usually held by either the lessor or the lender depending on the structure. Regardless, a leveraged lease doesn’t involve the transfer of the title to the lessee during the lease period.
Keep in mind that a leveraged lease is usually backed by a secured loan. This means that if a lessee stops making payments, the lessor can repossess the asset.
Leasing vs. Financing
Leveraged leasing and leveraged financing are typically the two main options for any person or company buying a car or other high-value asset. A leveraged lease provides a loan that covers an estimated value of a car over the leasing timeframe. Leveraged lease payments can potentially be lower because the loan does not cover the full value of the car.
An entity can also have the option to finance a car, in this scenario the car loan is similar to a home loan. The buyer of the car obtains a loan for the full value of the car and payments are created over a longer timeframe for repaying the car loan.
- Leveraged leases allow an entity to rent an asset for a specified amount of time using borrowed funds.
- A leveraged lease is usually used when an entity does not have the funds to buy the asset outright nor do they necessarily want to keep the asset for a long-term.
- In business accounting, a leveraged lease is referred to as a capital lease and specific accounting standards are required.
Special Considerations: Accounting for Leveraged Leases
Individuals usually do not need to worry about the accounting standards for leasing an asset with leverage but this would be a factor for a business. In business accounting, leveraged leases are referred to as capital leases.
To determine the difference, four criteria are used:
- The life of the lease is 75% or more of the asset's useful life.
- The lease includes a bargain purchase option whereby the lessee can purchase the asset at a lower price in the future than its fair value.
- The lessee gains ownership at the end of the lease period.
- The present value of the lease payments is greater than 90% of the asset's market value.
If any one of these criteria is met, then the lease is considered a capital lease and if not then the lease is considered an operating lease. Capital leases generally involve accounting for the leased asset similarly to an asset purchase. Operating lease accounting will generally require entries for the lease payments as operating expenses.
Operating Lease vs. Leveraged/Capital Lease
Individuals or business entities may encounter the differences in an operating lease vs. a leveraged/capital lease. In general, an operating lease does not include any options for buying the asset being rented. Common types of operating lease agreements include apartment leases and building leases.
Leveraged/capital leases are important to differentiate from operating leases in business accounting since accounting principles have different standards for the two.