⚖️ Advantages and Disadvantages of Leases — Intermediate Accounting

Hello and welcome to the session. This is Professor Farhat in which we would look at advantages and disadvantages of lease financing. Now, what is the idea of leases? Why do company lease? Well, when you need an asset, when you need a piece of equipment, a machinery, a computer, a vehicle, whatever you need for your business, you need to buy it. One way is to buy it and pay for it if you have the money. Another way is to go to the bank and get a loan or you can lease it from the seller or from the dealer or from the manufacturer. And the accounting for leases is covered in a in a separate recording. There's a series of them, one for the lessor, one for the lessee. In this session, we would look at advantages of leasing versus disadvantages of leasing. So, what are Why should you lease? Why you should not lease? We're going to cover seven advantages, four disadvantages. Bear in mind, those are not the only ones. There might be other advantages and disadvantages, but those are the one the main one that you need to be familiar with. For example, on the CMA exam or on your exam or on the CPA exam, you might have to answer a question about advantages and disadvantages. I'll go over each advantage separately, explaining what it is, maybe give an example just to kind of to give you a little bit deeper understanding so you will remember the answer. That's the whole purpose of it. But here's all the advantages and disadvantages, but you want to make sure you understand why, the reason behind it. Let's go ahead and get started. >> Before we proceed any further, I have a public announcement about my company, farhatlectures.com. My AI turns any lecture into a complete study system. You can create summary table, formulas, and example from each lecture. Flashcard builds from the lesson itself. A quiz built on the lesson. And as a bonus, convert any lecture into a portable short audio on the go. So, it helps you with the retention. No noise, no generic responses, and just clarity based on that specific lecture. Don't just watch, interact, test yourself, and retain the material using Farhat AI. Now, go to farhatlectures.com now and see how the AI can help you understand, practice, and retain the material. >> Starting with advantages. Well, advantage number one, leasing may be less expensive than borrowing. It Notice here may. Maybe, it doesn't have to be, but may. Why? The lessor often receive tax benefit tax benefit manufacturer discount or bulk purchasing advantage. And because of that, the lessor, the person that's leasing you that asset, might have the asset at a lower cost, and as a result, they can pass those savings to you as the lessee. For example, a $100,000 equipment needed. Option one is to borrow money and buy it from the bank and repay it over 5 years with interest, and the total cost might be 125 cuz you have to pay an additional $25,000 in interest. The other option is to lease it. Maybe the lessor has purchasing advantages. Therefore, the total lease payment as a result will be 112. So, under certain circumstances, you could have savings. Again, that may not be always the case, but sometime it is the case, and often it is the case in leasing. The other advantage, and that's a big one, which one of the big ones, especially for small businesses or startup, is little to no down payment required. Leasing often provide close to 100% financing. What does that mean? It means if you have cash, use it for something else. And if you don't have cash, you are going to be able to use the asset. So, there's no down payment or little down payment versus a loan. And a loan, you know, if you want to buy an asset, you have to put a down payment. Could be up to 30%. You might have to put the asset itself as a collateral. You must have a strong his credit history. And the bank might put restrictive condition on you. We'll talk about those strict restrictive condition later. Leasing, often time you have no down payment, zero down payment. You can finance the whole thing. The easier restriction on the credit because the owner can always take back the asset and cash stays within the business. So, for example, a startup company needs five delivery van and lacks 150,000. They don't have the down payment. They can lease the vans and put zero down. Again, there are This is some of the advantages. But again, the disadvantages could be at the end you don't own them. The payment overall over 5 years maybe it's higher, but at least now you can get started. This is the advantages. So, you have the cash available for payroll, inventory, and you're able to buy the or not buy. You have control over these delivery vans. You have the right to use them. Advantage number three is fewer restrictive covenant. And this is what I meant to say restrictive condition. What does that mean? It means when you take a loan out, often times the bank will need to protect themselves. So, they include strict rules that limit management flexibility. Lease agreements tend to impose fewer restriction because there's more flexibility. So, the bank might have covenants. Covenants are conditions. For example, you have to maintain a minimum liquidity ratio. For example, your current assets should always be two times your liabilities. That's a restrictive covenant. It means from a decision perspective, you have to make sure when you make financial decision, your your assets are two your current assets are two times greater than your liability. Another thing is that to equity limit. What is that to equity? Same thing. You cannot you cannot have a certain amount of debt relative to your equity. For example, it could be 1.5 to 1 restriction. If you want to borrow money, you cannot borrow money. Those are restriction. Three, dividend restriction. You cannot pay dividend if your earnings falls below a certain number. The bank can tell you that. If they're going to give you a bank, they can put you under those conditions. More conditions. Capital expenditure. Well, you cannot get any large purchase before the bank approves the purchase. Why? Because they want to protect the funds that you have that you're going to be paying them back. Those are all restriction. From a leasing perspective, typically they contain no or fewer covenant giving management operational flexibility. You have more freedom in making capital decision, buying new asset, no minimum uh ratio requirement, dividend usually not restricted, greater management autonomy, and better negotiation position. Simply put, more flexibility, and that's better for management. Advantage number four. I would say this is the most important. This is even more important than this is more important than number two in my opinion. But again, depending on what your uh your priorities. Little to no down payment, but what's more important is when you have advantage number four is you avoid obsolescence. You reduce obsolescence risk. And what's obsolescence risk? Technology evolve rapidly, whether it's AI or pharmaceutical or telecom. So, short-term leases let companies upgrade equipment without being stuck with the outdated asset. So, we might have a three-year server lease timeline. So, you you lease a new server. Year three, the lease term ends and you can upgrade to the new server. If you buy the server, then you are stuck with it maybe 4 years. So, who would benefit the most from this reduced obsolescence risk? There are certain industries, that's why they lease, because obsolescence risk. One is, I just mentioned, technology. Computer servers, software, equipment. Is this the only one? Absolutely not. Think about health care. New MRI machine, new diagnostic tool. You want the latest, the best one. So, if you lease it, you will be able to do that. And I even know a few people that work in this industry. Telecom, the same concept. Network infrastructure, cell towers. Airline companies, aircraft are leased for short-term cycles. If there's any update, they can take advantage of the update. Other advantages of leasing is tax deductible payment. Lease payment are generally deductible as business expense, therefore reduce your taxes. And that's Leasing land gives a deduction, owning the land will give no depreciation under GAAP. Fixed rate financing. Often time, the lease payment is fixed. Many leases will have a fixed lock payment regardless of the interest rate. The loan, sometime they might have variable rate, which is riskier. The third advantage, it's easier than borrowing. Once again, bank require extensive credit review, financial statement, collateral, so on and so forth. Leasing companies, they move faster because they deal with small businesses and startup. So, those are some of the advantages. Obviously, there are disadvantages. And one of the disadvantages is sometime the payment over all could be higher, over all. So, over the life of the deal it could be higher, and you need to make that payment regardless. Just like in a loan, and the payment could be over all higher. So, year one through year two, the business is thriving, you're paying 2,500 for leasing kitchen equipment. That's great. If the business suffers, if revenue drops 40%, you still have the payment. If the business is struggling, you still have to make the payment. So, this is one disadvantage, but this is when it comes to lease as well as loan. But if you own it, you don't have to keep making the payment. So, the total obligation could be 2,000 and 10 210,000 regardless of the performance. And the other thing is leases now, whether it's operating lease or a financing lease, specifically if it's considered an operating lease, you would still show the asset and the liability. In the past, companies if they did an operating lease, they would not hide, not show the liability. But that's beside that's old rules, just FYI. In other words, once you have a liability, you have you are stuck with that liability. The disadvantage number two is maintenance cost may still be the lessee's responsibility. So, you're buying an you're leasing an asset, but at the same time you have to maintain it. You have to insure it. You have to repair it. And that's adding to the true cost. So, you might lease a truck, you still have to change the oil, the tires, general repair, insurance premium, annual inspection. And those are hidden costs that could add up to a lot. So, lessees still bears the cost without gaining any ownership. At the end of the day, you're going to return that truck to the dealer. So, the true cost would include additional maintenance cost. If you don't account for that, then you're not seeing the big picture. So, that's a disadvantage of leasing. A third disadvantage is leasing might cost more over time. And I mentioned this when I talked about leasing might be lower. Leasing might exceed the purchasing of the asset. The difference represent an embedded financing cost. So, you might buy an asset today for 50,000. Or you might make payments 1,100 for 60 months, end up paying 66,000 or sometime more. So, notice here overall, if we add up all the payment without considering the time value of money, you're paying more. But again, you have to consider the time value of money uh to determine the true cost. But the point is leasing overall will cost more money. But why would people are willing to lease? Because they don't have the 50,000. All what they need now is 1,100 to get started, and that's why they will choose that. But the extra cost over time could be surely a negative. The more you pay, the worst economically off you are. Advantage number four, and this is an important one, especially if no ownership is there at the end, is there's no ownership equity. It's like you're throwing your money away. Unlike purchasing, leasing leasing does not build ownership equity. So, simply put, you maintain this asset, you repair it, you make sure it's doing good. Then at the end of the day, you return it, and you don't get anything. Assuming that you have no purchase option um to buy it. So, so if we look at a 5-year comparison, you might purchase an equipment paying 10,000 every year for you bought it for 50. At the end of the day, you might be able to resell it for 20. It has equity. Or you might lease an equipment for the same amount, 10,000, and be left with nothing. So, asset return, the equity is zero, unless there is a bargain purchase price exercised, but we're assuming here there is none. Here's a summary of the lease versus purchase borrow advantages and disadvantages. Again, this is a good one to review. And let's take a look at this multiple choice question from farhatlectures.com. Which of the following is an advantage of leasing financing? So here we're looking for one advantage. So we have one correct answer and three incorrect. It's easier to deal with the incorrect ones. Why? Because there there there are more more of them. Lease payments build ownership equity over time. No, lease payments is rental. You don't build you don't you're not getting any ownership. There's no equity at the end of the day. Leases often require little or no down payment. Is this an advantage of leasing? That's one of the main advantages of leasing is you don't have to put a lot of money up front. Little or to none sometime. We'll say this is advantage. This could be the correct answer. If you don't have time, don't look at C and D. But if you have time, check C and D. Total lease payment always less less than the purchasing. Not necessarily. Lease payment could be higher. The [snorts] lessee is never responsible for maintenance. No, the lessee could be responsible for maintenance and often time the lessee is responsible for maintenance cost. Now what should you do now? Whether you are a CPA, CMA, accounting student, the best thing to do is to go to farhatlectures. Look at additional lectures, exercises, simulation, cases. And if you're using my quiz, you can ask AI to explain the material, explain the correct and incorrect answer, create a similar MCQ about the topic. The best investment you can make is invest in yourself. No one can take that away from you. And God bless.