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Lease or buy, same same but different?

With the new lease accounting standard now — or soon to be — applicable for most companies, it’s a good time to consider whether alternative decisions could be made around financing business assets.

Insights Paul O’Brien, Katelyn Bonato and John Ratna, PwC 30 May 2019
— 4 minute read

When financing business assets, companies generally have two options available to them: lease or buy. Historically, operating leases were useful in that they generally kept arrangements off balance sheet. That is, no large assets or liabilities needed to be recognised, just a simple annual charge for use of the asset.

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This allowed companies to prevent an impact on capital metrics such as return on invested capital (ROIC) and return on assets (ROA). However, with the introduction of AASB 16 Leases (AASB 16) that will change.

When thinking about how the change will affect your company, it’s useful to look at the impact on your financial statements as a result of (i) leasing an asset prior to the application of AASB 16, (ii) leasing an asset under AASB 16, and (iii) buying an asset by borrowing funds. We’ve summarised the impacts below:

 

Leasing asset pre-AASB 16

Leasing asset  under AASB 16

Borrowing to buy an asset

Balance sheet

Asset recognised

Liability recognised

Income statement

Depreciation expense

Interest expense

Rental expense

The simple conclusion is that under the new guidance, there are now minimal differences between leasing assets and borrowing funds to buy assets (with the proviso of all other things being equal, such as expected future usage period).

However, let’s consider two scenarios, being:

  • Leasing or buying a new greenfield asset; and
  • Buying out an existing lease arrangement.

Leasing or buying a new greenfield asset

Now that the benefits of an off-balance treatment for leases have been removed, what actually matters? The key influence on profit in any asset arrangement has always been the interest rate applicable. Historically, companies might trade interest points for the convenience of an off-balance sheet accounting treatment; however, this no longer matters. Every lease is now treated as a financing arrangement, similar to a borrowing, unless it falls into certain very limited exceptions.

So let’s look further at the economics of leasing versus buying scenarios and the impacts on key profitability and capital metrics, as summarised below:

Metric

Impact of leasing asset

Impact of buying asset

Commentary

Earnings before interest, tax, depreciation and amortisation (EBITDA)

No impact

No impact

●      Subsequent depreciation and interest expense sit outside EBITDA, therefore no impact on this metric under either option.

Profit before tax (PBT)

Higher interest charge

Volatility over residual asset risk

●      Depreciation expense likely to have a similar impact on PBT under both options.

●      Interest from a lease vendor is likely to be higher than general commercial borrowings.

●      Lease arrangements typically lock in residual asset risk albeit at a cost.

ROIC

Similar

Similar

●      As both models incur interest and  depreciation, and require the asset to be funded, any differences are likely to be marginal.

●      Minor distortions may arise where makegood provisions are recognised or the technicalities of the leasing literature allow for slightly lower initial liabilities to be recognised (i.e. not necessarily including all indexation factors).

ROA

Similar

Similar

●      With similar assets recognised under both options, a similar reduction in ROA will occur. Residual value volatility may affect ROA in a buy scenario.

Given the summary above, things to think about when considering a lease versus buy arrangement include:

  • Cost of funds should be cheaper in a borrowing arrangement where security can be offered on a fixed and floating basis, as opposed to on a specific asset under a leasing arrangement. For an asset that is certain to be fully utilised over its entire useful life, purchasing will likely give a better return on capital invested.
  • If flexibility by way of renewal options is needed, leasing arrangements are likely to be far simpler. Asset renewal is as simple as ‘handing back the keys’ at the end of the term. This means no complex stamp duty concerns or residual asset value risk in disposing of unwanted assets.
  • Buy arrangements ensure all asset risk rests with a purchaser. Lease arrangements, potentially, give greater flexibility in sharing such risk through the use of hybrid payments that combine minimum take or pay baseline amounts and usage-based fees.
  • The accounting now has less of an impact, given every lease is treated as a finance lease. Therefore, the lease or buy decision for a new asset should now depend on interest savings and the subsequent tax and regulatory considerations. Interest savings should be balanced with the desired flexibility and ease of asset renewal that a lease provides.

Buying out an existing lease arrangement

Lastly, let’s give some thought to buying out existing lease arrangements. In general, the same considerations apply. There is no particular difference, conceptually, in the prospective accounting for a new lease under AASB 16 or a purchased asset arrangement funded by debt.

However, in our experience, no lease provider is generally willing to give up lost profit embedded in already established arrangements. As such, care should be taken to properly understand the economics, including the independent market value of the asset to be purchased. Accounting would potentially require such an asset to be initially recognised at fair value. Market fluctuations in asset values, interest rates and credit rating since the inception of the original lease arrangement may give rise to a day 1 impairment loss if the asset was purchased.

Future focus

With the removal of off-balance sheet treatment under leasing arrangements, companies will now shift their focus to other key drivers, such as cost of debt and asset management, when considering how to finance business assets. 

Paul O’Brien, Katelyn Bonato and John Ratna, PwC

Lease or buy, same same but different?
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