What is Leveraged Lease?
Leveraged lease refers to a lease agreement wherein the lessor acquires an asset partially financed by the financial institutions and lease out the same to the lessee for the agreed lease payments. The lessee transfer the lease rentals directly to an escrow account maintained with the financial institution by the lessor. The financial institutionFinancial InstitutionFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. charges the loan installments (principal as well as interest) from the proceeds available in the escrow account and balance amount if any gets transferred to the account of the lessor.
Example of Leveraged Lease
- ABC Inc. requires a piece of new equipment for the US $ 1 million for 2 years for research purposes. Since ABC Inc. needs the equipment for a relatively short period of time, buying it would not be the right decision for the company. Hence, the company decided to take the equipment on leaseEquipment On LeaseEquipment Lease is where the equipment owner allows another party to use it in exchange of periodic rentals with no transfer of ownership and has the right to cancel the lease right away in case of breach of the lease agreement..
- XYZ Inc. is considering to buy similar equipment and ready to lease it out to the ABC Inc. post-acquisition. However, XYZ Inc. has the only US $ 200,000 in hand and thus wishes to finance the balance of US $ 800,000 from the financial institution @ 7% interest rate.
- This is a transaction of leveraged lease wherein XYZ Inc. is the lessor who has part-financed the equipment from the lender (financial institution) on a non-recourse basis to lease it out to ABC Inc (the lessee).
- In turn, ABC Inc. (the lessee) will pay the lease rentals to the escrow accountEscrow AccountThe escrow account is a temporary account held by a third party on behalf of two parties in a transaction. It reduces the risk of failing to oblige the transaction by either of the parties. It operates until a transaction is completed and all the conditions are met. maintained with the financial institution. The financial institution, after adjusting the principle and interest due on loan, remits the excess receivable to XYZ Inc. (the lessor).
Accounting Standard Codification 840 (ASC 840) deals with accounting for capital leasesCapital LeasesA capital lease is a legal agreement of any business equipment or property equivalent or sale of an asset by one party (lesser) to another (lessee). The lesser agrees to transfer the ownership rights to the lessee once the lease period is completed, and it is generally non-cancellable and long-term in nature. in the United States. According to ASC 840, a lease is considered a leveraged lease, if:
The lease agreement satisfies any of the following:
- There will be transfers ownership of the asset at the end of lease term
- The lease allows the lessee an option to but the asset at a price lower than fair value.
- The lease term is for a major part of (more than 75%) the remaining economic life of the asset.
- The present value of minimum lease payments is more than 90% of the fair value of the leased asset.
The lease agreement satisfy all of the following:
- The collectibility of minimum lease payment is certain and reasonably predictable.
- The lessor is not required to incur any additional cost if such cost is not reimbursable.
- The lease involves three parties: a lessor, a lessee, and a lender.
- The asset is largely financed by the lender on a non-recourse basis.
- The net investmentNet InvestmentNet investment is calculated as capital expenditure minus non-cash depreciation and amortization for the period, and it indicates how much the company is investing to maintain the life of its assets and achieve future business growth. of the lessor declines during initial periods and rises during later periods.
Further, as per ASC 840, in case of a Leveraged Lease, the lessor would recognize the following:
- Lease rentals receivables, net of principal and interest payments
- Unearned incomeUnearned IncomeUnearned income refers to any additional earnings made from the sources other than employment, such as returns on investments, dividends on bonds and equities, interest on savings, etc.
- The outstanding (residual) value of the leased property
- The amount of investment tax credit, if any availed.
The lessee simply recognizes the payment of lease rentals as an expense and charge against its profit.
Important Points to Consider in Case of Leveraged Lease
- Usually, in the case of a leveraged lease, lessor put 20%-30% contribution from its own funds and balanced is financed through a bank, financial institution or third party lenders for the acquisition of an asset.
- The loan financed by the lenders is generally of non-recourse nature. That means lessor is not liable for repayment of loan installments in case of a default, and the lender can recover the installments only from the lease rentals paid by the lessee.
- Since the lender will finance the asset on a non-recourse basis, it is important for the lender to evaluate the creditworthiness of the lessee as well before the sanction of the loan facility.
- In the United States, the Accelerated Cost Recovery System (ACRS) (as introduced through The Economic Recovery Tax Act 1981) allows the purchaser of the asset for availing Investment Tax Credit. By availing Investment Tax credit, the purchaser can deduct a percentage (as defined in the law)of the asset price from its taxes for the year in which the asset was placed in service.
- Additionally, the purchaser of the asset will also get the tax benefit of the accelerated depreciationAccelerated DepreciationAccelerated depreciation is a way of depreciating assets at a faster rate than the straight-line method, resulting in higher depreciation expenses in the early years of the asset's useful life than in the later years. The assumption that assets are more productive in the early years than in later years is the main motivation for using this method. deduction.
- The leveraged lease is beneficial for the lessee when lessee requires the asset for short term purposes as lessee can get the asset through lease instead of buying it.
The leveraged lease is a type of capital lease that involves three parties: a lessorLessorA lessor is an individual or entity that leases out an asset such as land, house or machinery to another person or organization for a certain period., a lesseeLesseeA Lessee, also called a Tenant, is an individual (or entity) who rents the land or property (generally immovable) from a lessor (property owner) under a legal lease agreement. , and a lender. The lessor acquires the asset through partial equity funding and the remaining balance from the debt as financed by the lending institution on a non-recourse basis. After the purchase of the asset, the lessor leases it out to the lessee in consideration of lease rentals, which directly goes to the lending institution first and the balance receivable if any gets transferred to the lessor.
This has been a guide to What is Leveraged Lease & its Definition. Here we discuss the examples of the leveraged lease along with accounting treatment. You can learn more about accounting from the following articles –