Leasing is often thought of as a simple rental agreement: A company makes payments on a piece of equipment and returns it when the agreement ends. While it’s true, that is one type of lease, it is not the only leasing option. Leasing agreements go by many names, but two of the most common types are fair market value (FMV) leases and capital leases. Which one is the best option depends on the type of equipment and the nature of the business leasing the equipment. Both have benefits for both the lessee and the lessor.
Fair Market Value Leases
Also known as operating leases, or “true leases,” these types of agreements involve essentially renting the equipment out for a set period of time, with an option after the agreement ends to purchase the equipment at fair market value — hence the name.
The equipment is never purchased during the length of the lease, and so it does not appear on a company’s books as either an asset or a liability. As far as accounting goes, the lessee treats the lease payments as a deductible operating expense.
In other words, an FMV lease doesn’t create more debt for the company. It’s written off as an operating expense, which doesn’t affect your return on assets or your debt ratio at all. It frees up a business’ credit lines to pursue other financing if necessary.
Fair market value leases are ideal for technology and other industries where the equipment outdates itself fairly quickly. FMV leases are often used in the Industrial market when a specific machine is needed for a short term or specific project and may have not utility in the shop after its initial use(s) They tend to be shorter term with lower monthly payments. When the lease is up, the lessee is under no obligation to purchase the equipment — though it can, if the purchase makes sense. Otherwise, the lessor will either resell or dispose of the equipment. It’s worth noting that the FMV purchase price isn’t determined until the end of the lease, which is the opposite of how a capital lease works.
Capital leases are known by many names — Lease Purchase, finance leases, nominal leases, sometimes even “buck-out” or “dollar-buyout” leases. The reason why is pretty simple: Once the leasing agreement is up, the lessee purchases the equipment for a nominal price (sometimes as low as $1). This is not an optional purchase — it is planned from the beginning.
For all intents and purposes, a capital lease is a loan. There are fixed payments, and the lessee has ownership of the equipment during the lease, which allows it to depreciate the equipment and even take advantage of Section 179 incentives and Bonus Depreciation. Consequently, the lease terms tend to be longer, with higher payments — though this is not always the case. In some situations, an unwitting business owner may find their lease agreement includes a large balloon payment at the end of the agreement — effectively negating any savings found in a low interest rate on the lease agreement.
Capital leases are very defined — in fact, to be considered as such, they must meet at least one of the following four criteria as outlined in Statement 13 from the Financial Accounting Standards Board:
a. The lease transfers ownership of the property to the lessee by the end of the lease term.
b. The lease contains a bargain purchase option.
c. The lease term is equal to 75 percent or more of the estimated economic life of the leased property.
d. The present value at the beginning of the lease term of the minimum lease payments equals or exceeds 90 percent of the excess of the fair value of the leased property.
If the lease meets none of these criteria, it is treated as an operating or FMV lease.
Which is the Best Option, a Capital or FMV Lease?
Both types of leases have their benefits for both the company providing the equipment and the business leasing it. Ultimately, the nature of the equipment and the industry will have a major influence on which is the better option for both parties. Talk to your accounting department and reach out to EFG to learn more about leasing options and creating a financing partnership for your customers!