The decision to lease vs buy is a recurring challenge for CIOs struggling with financing IT equipment. Adding to the challenge is the increasing number of options to accomplish IT projects using cloud computing or vendor hosted managed services. Often CIO’s and CFO’s get tangled in the lease vs buy decision prematurely which can lead to a bad decision with lasting effects.
The best place to start any discussion on IT leasing begins with the organization’s financial management strategy around asset acquisitions and the use of capital. The fundamental first question to be addressed in any lease vs buy decision is whether or not it makes sense to own, or not own, a given asset. In other words, do you want to own the asset or just use it?
The reasoning behind this is that asset ownership is a decision independent of financing the asset’s acquisition and serves as a major input into the lease vs buy analysis. CIO’s need to work closely with their CFO’s and other peers in assessing asset ownership decisions as it can change with the ups and downs of the cost of capital and from one asset to another.
The next question to answer once asset ownership is decided is on how to finance the asset acquisition. This is when things can get tricky for CIO’s who may not be comfortable with the IT financial analysis or who may not be using an IT project business case template that includes calculations for internal rate of return, net present value, payback period, or return on investment. Too often the financing decision is oversimplified as a choice between using capital funds or operating funds, or CapEx vs. OpEx to use today’s chic speak.
What many fail to realize on the decision of CapEx vs. OpEx is not that it is a decision of lease vs buy, instead it is a decision what type of lease to use – at least for now. In a proposed change to the accounting treatment of leases the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) has proposed changes to Standard No. 13 on leases to improve clarity in financial statements for investors. Although FASB has sought another round of comments, the technical decisions made as of August 18th are expected to be adopted which will have an impact on leasing decisions. Because the Government Accounting Standards Board (GASB) typically follows FASB and IASB, we can expect GASB to adopt similar changes for the public sector.
For now though we must continue under the existing rules. To help CIO’s with developing a better understanding of leasing I have tried to provide a good overview of the major aspects here as a starting point for developing a better understanding of how to decide when leasing is potentially a better route for financing IT initiatives. I will also note here every CIO should sit down with their CFO to develop a shared understanding of leasing and the organization specific issues to be taken into account.
Types of Leases
Leases takes on one of three different forms: (1) sale-and-leaseback arrangements, (2) operating leases, and (3) straight financial, or capital leases.
Sale and Leaseback:
Under a sale and leaseback, a company that owns equipment sells the property and simultaneously executes an agreement to lease the property back for a specified period and terms. Often just referred to as leaseback, organizations use this method when they own an asset and want to extract the equity from it while continue to enjoy its use. This is uncommon in IT.
Operating leases, often called service leases, provide for both financing and maintenance. Important characteristics ordinarily found in an operating leases are: (1) the leases call for the lessor to maintain and service the leased equipment, (2) the cost of providing maintenance is built into the lease payments, (3) they frequently contain a cancellation clause that gives the lessee the right to cancel before the expiration of the agreement, an important consideration in IT since it means the equipment can be returned if it is rendered obsolete by technology developments or it is no longer needed.
Financial, or Capital, Leases:
Financial leases, mostly referred to capital leases, are differentiated from operating leases in three aspects: (1) they do not provide for maintenance services, (2) they do not have cancellation provisions, and (3) they are fully amortized which means the lessor receives payments which are equal to the full price of the leased equipment plus a return on their investment.
Financial Treatment of Leases
Lease payments are shown as operating expenses in the income statement. However, when a lease is to be classified as a capital lease it must also be capitalized and shown directly on the balance sheet. Alternatively, when none of the above criteria are met, neither the leased assets nor the liabilities under the lease agreement appear on the balance sheet. For this reason, operating leases are often called off balance sheet financing.
The differences between a capital and operating lease can have significance on an organization’s financial statements. Therefore it is advisable to fully understand how leasing standards apply to IT asset acquisition in your environment. And, to recognize it is not the same even from one year to the next let alone from one organization to another.
Determining Lease Classification
FASB issues guidelines and recommendations that become the generally accepted accounting practices (GAAP) which include criteria for examining leases to determine their treatment as operating or capital.
An operating lease is defined by FASB one that does not meet the criteria of a capital lease. If a lease does not meet any of the criteria for a capital lease it is then classified as an operating lease.
FASB has established four criteria for determining lease classification. If any one of these criteria is met, the lease is considered to be a capital lease. If none of these criteria are present, the lease is an operating lease. At its inception, a lease must be treated as a capital lease if it meets one or more of the following criteria:
- Under the terms of the lease, ownership of the equipment is effectively transferred from the lessor to the lessee by the end of the lease.
- The lessee can purchase the equipment or renew the lease at less than a fair market price when the lease expires, whereas it is likely the lessee will exercise this right and elect to buy the equipment (bargain purchase option).
- The term of the lease is for a period equal to or greater than 75 percent of the assets life.
- The present value of the minimum lease payment is equal to or greater than 90 percent of the initial value of the asset.
It is absolutely essential that CIO’s and yes CFO’s understand that most leasing companies write some form of capital lease as their bread and butter product. Still they recognize there is a lot of extra income to be made structuring leases that satisfy FASB 13 requirements. For this reason companies should exercise due care to be sure leases are structured and treated properly. Remember, just because the vendor tells you it is an operating lease doesn’t mean it is one. You need to examine it yourself against the criteria as a policy of trust-but-verify because you auditor certainly will.
Lease vs Buy Decision
The lease vs. buy decision, which is as much an own vs. use decision, that is influenced by various economic, psychological, political, and technological factors. These factors vary in significance for private and public entities as well as for-profit and non-profits.
The important ratios are return on assets (ROA) and return on equity (ROE). True (not necessarily operating) leases may have the effect of increasing reported earnings because the payments do not lower pre-tax income as much as depreciation and interest expenses. And, obviously, if you increase net income after taxes, you increase ROA and ROE.
Corporations often find that their objectives in financial statement and tax reporting are at odds. Financial statements look best when income is reported as early as possible and matching assets and liabilities are removed from the balance sheet. Taxes, however, are minimized when income for tax reporting purposes is delayed as long as possible.
Under an operating lease, the lessee has nothing on its balance sheet, so current income and taxes are high. Under capital lease accounting, the lessee records both the asset and its financing on the books; the result is low current income and low taxes.
When equipment acquisition costs exceed capital budgets, division managers often must go to a higher authority for the money. Since leasing payments can come from an operating budget, lower level decision makers can often make the financing decision themselves.
Many businesses have discovered they don’t need to own the equipment they use. In the past renting and leasing were frowned upon. Today’s psychology looks more to the economics rather than the moralities of ownership. Cloud computing and new offerings in vendor hosted services as truly testing the psychological factors for asset ownership and financing IT initiatives. The proposed FASB 13 changes will provide clarification for cloud computing and managed hosting services but not until passed and adopted by GASB will public colleges and universities be able to take full advantage.
Relative to IT assets, there is a growing disconnect between the technological life of and the economic life of an asset. The technological life reflects how long the asset can be used before it becomes functionally obsolete or when the operational costs are more expensive than those of newer products.
The economic life of an asset is the period of time when the asset has some economic value (residual or fair market value). Because many IT systems have longer technological lives many enterprises have decided to keep equipment for longer periods of time. Superficially, it would appear that if residual values were expected to be large, owning would have an advantage over leasing and a longer lease term is typically more costly than an outright purchase.
This means it is becoming increasingly difficult to obtain operating lease treatment for the length of time enterprises want to use their equipment. As a result, many enterprises have moved to a strategy of selective leasing, whereby they only lease equipment they intend to keep for shorter periods, and purchase equipment they intend to use for longer periods.
Public sector institutions across the country are under dramatic budget pressures. And many of these same institutions have not kept up with appropriate lifecycle refresh creating the perfect storm of obsolete inventories with rising support costs and a lack of funding to pay for the needed refresh. This might be the case for long overdue PC refresh that drives you into a VDI project you are not ready for just to avoid the desktop refresh.
As I have said before, one of the primary roles of a CIO is that of mitigating the risk of IT related procurement decisions. CIO’s considering leasing as a way to fund IT projects must work closely with their counterparts in finance and the CFO to fully understand the implications. Before you have that conversation, be sure you are comfortable with the basics and have worked out the rationale for your options.