Understanding the nuances between lease and finance leases is crucial for any business, especially when dealing with significant assets. Both options allow companies to utilize assets without outright purchase, but their accounting treatment, risk allocation, and long-term financial implications differ significantly. This article dives deep into the key differences between iCapital leases and finance leases, providing clarity on when each option is most suitable.

What are iCapital Leases?

iCapital leases, often referred to as operating leases under traditional accounting standards, are agreements where the lessor (the asset owner) retains most of the risks and rewards of ownership. Think of it like renting an apartment: you get to use the space, but the landlord is responsible for major repairs and ultimately owns the property. These leases are typically shorter-term compared to finance leases, and the lessee (the company using the asset) doesn't assume ownership at the end of the lease term. With iCapital leases, the asset remains on the lessor's balance sheet, and the lessee records lease payments as operating expenses. This can be attractive for companies looking to keep debt off their balance sheet, as the lease obligation isn't recognized as a liability. However, under newer accounting standards like ASC 842 and IFRS 16, even operating leases are now recognized on the balance sheet, albeit in a different manner than finance leases. This change aims to provide a more transparent view of a company's lease obligations.

Key characteristics of iCapital leases include a lease term that is significantly shorter than the asset's useful life, no transfer of ownership to the lessee at the end of the lease, no bargain purchase option for the lessee, and a present value of lease payments that is substantially less than the asset's fair value. Maintenance and insurance responsibilities often fall on the lessor. For businesses that need assets for a limited time or want to avoid the responsibilities of ownership, iCapital leases can be a flexible and cost-effective solution. They are particularly useful for assets that may become obsolete quickly or require specialized maintenance that the lessee prefers to outsource.

From a financial perspective, iCapital leases can impact a company's financial ratios differently than finance leases. Since the asset isn't on the lessee's balance sheet (or was not, under older accounting standards), ratios like return on assets (ROA) may appear higher. However, the lease payments are still an expense, which affects profitability. Under the new accounting standards, the impact on financial ratios is more complex, as both an asset (right-of-use asset) and a liability (lease liability) are recognized. It's essential for companies to carefully analyze the financial implications of iCapital leases under the current accounting rules.

Delving into Finance Leases

On the flip side, finance leases (also known as capital leases under older accounting standards) are essentially a way to finance the purchase of an asset over time. It's like taking out a loan to buy a car, but instead of owning the asset outright from day one, you lease it for a period and then typically acquire ownership at the end. With finance leases, the lessee assumes most of the risks and rewards of ownership, and the asset is recorded on the lessee's balance sheet along with a corresponding lease liability. This means the company is essentially treated as if it owns the asset for accounting purposes, even though it's technically leasing it.

Finance leases are generally longer-term than iCapital leases, and they often include a transfer of ownership to the lessee at the end of the lease term. Even if there isn't a direct transfer of ownership, the lease may be classified as a finance lease if it contains a bargain purchase option, allowing the lessee to buy the asset at a significantly reduced price at the end of the lease. Another trigger for finance lease classification is if the lease term is for a major part of the asset's remaining economic life (typically 75% or more), or if the present value of the lease payments is substantially all (typically 90% or more) of the asset's fair value. The lessee is usually responsible for maintenance, insurance, and other costs associated with the asset.

The accounting treatment for finance leases involves recognizing depreciation expense for the asset and interest expense for the lease liability on the lessee's income statement. The principal portion of the lease payment reduces the lease liability on the balance sheet. Because the asset and liability are recognized on the balance sheet, finance leases can have a significant impact on a company's financial ratios. Debt-to-equity ratios will be higher, and return on assets may be lower compared to iCapital leases (especially under older accounting standards where iCapital leases were off-balance-sheet). However, the company also benefits from the tax advantages of depreciation. Finance leases are suitable for companies that intend to use an asset for most of its useful life and want to eventually own it. They can be a good option when a company lacks the upfront capital to purchase the asset outright but can afford to make lease payments over time.

Key Differences: iCapital Leases vs. Finance Leases

Let's break down the key differences between iCapital leases and finance leases in a more structured way:

• Ownership: With iCapital leases, the lessor retains ownership of the asset. With finance leases, ownership typically transfers to the lessee at the end of the lease term, or the lessee has the option to purchase the asset at a bargain price.
• Balance Sheet Impact: Under traditional accounting, iCapital leases were often kept off the balance sheet (though this has changed with newer standards). Finance leases are always recorded on the lessee's balance sheet as both an asset and a liability.
• Lease Term: iCapital leases usually have shorter lease terms compared to finance leases. Finance leases often cover a major portion of the asset's useful life.
• Responsibilities: In iCapital leases, the lessor often retains responsibility for maintenance and insurance. In finance leases, the lessee typically assumes these responsibilities.
• Accounting Treatment: iCapital leases result in lease payments being recorded as operating expenses. Finance leases involve recognizing depreciation expense and interest expense.
• Financial Ratios: iCapital leases can have a different impact on financial ratios than finance leases, particularly under older accounting standards. Finance leases generally increase debt-to-equity ratios and may lower return on assets.
• Risk and Rewards: iCapital leases mean the lessor retains most of the risks and rewards of ownership. Finance leases mean the lessee assumes most of these risks and rewards.

When to Choose iCapital Leases

Choosing between iCapital leases and finance leases depends heavily on a company's specific circumstances and financial goals. iCapital leases are generally a better choice when:

• The asset is needed for a short period: If you only need the asset for a fraction of its useful life, an iCapital lease can be more cost-effective than a finance lease or an outright purchase.
• You want to avoid the responsibilities of ownership: If you don't want to deal with maintenance, insurance, and other ownership-related costs, an iCapital lease can be a good option.
• The asset may become obsolete quickly: For assets that are prone to technological obsolescence, an iCapital lease allows you to upgrade to newer models without being stuck with an outdated asset.
• You want to keep debt off your balance sheet (though the impact is now limited by new accounting standards): While new accounting rules require both types of leases to be on the balance sheet, the presentation and impact on some ratios can still differ.
• Flexibility is paramount: iCapital leases offer more flexibility, allowing you to easily return the asset at the end of the lease term without the complexities of selling or disposing of it.

Consider a construction company that needs a specialized crane for a specific project lasting only two years. Purchasing the crane outright would be a significant capital investment, and a finance lease would commit them to a long-term obligation. An iCapital lease allows them to use the crane for the duration of the project and then return it, avoiding the costs and responsibilities of ownership.

Situations Favoring Finance Leases

Finance leases are a more appropriate choice when:

• You intend to use the asset for most of its useful life: If you plan to use the asset for a long period, a finance lease can be a cost-effective way to acquire it over time.
• You want to eventually own the asset: If you want to own the asset at the end of the lease term, a finance lease is the way to go.
• You're willing to assume the risks and rewards of ownership: If you're comfortable with the responsibilities of maintenance, insurance, and other ownership-related costs, a finance lease can be a good option.
• You lack the upfront capital to purchase the asset outright: A finance lease allows you to acquire the asset without a large initial investment.
• Tax advantages are a priority: The depreciation expense associated with finance leases can provide tax benefits.

Imagine a manufacturing company that needs a new piece of equipment to expand its production capacity. The equipment is expected to last for ten years, and the company intends to use it for the entire period. They don't have enough cash on hand to purchase the equipment outright, but they can afford to make lease payments over time. A finance lease allows them to acquire the equipment, use it for its entire useful life, and eventually own it, while also benefiting from the tax advantages of depreciation.

Navigating the Accounting Standards

It's crucial to remember that accounting standards for leases have evolved significantly. ASC 842 in the United States and IFRS 16 internationally require companies to recognize most leases on the balance sheet, regardless of whether they are classified as iCapital leases or finance leases. This means that both types of leases will result in the recognition of a right-of-use asset and a lease liability on the lessee's balance sheet.

However, the accounting treatment still differs in some respects. For iCapital leases, the lease expense is typically recognized on a straight-line basis over the lease term. For finance leases, the asset is depreciated, and interest expense is recognized on the lease liability. The classification of a lease as either an iCapital lease or a finance lease can also affect the presentation of cash flows on the statement of cash flows.

Companies need to carefully analyze the lease agreements and apply the appropriate accounting standards to ensure accurate financial reporting. This often involves calculating the present value of lease payments and determining whether the lease meets the criteria for classification as a finance lease. Seeking advice from accounting professionals can be invaluable in navigating the complexities of lease accounting.

Making the Right Choice

Deciding between iCapital leases and finance leases is a strategic decision that should be based on a thorough analysis of a company's needs, financial situation, and long-term goals. Consider the following factors when making your decision:

• Asset Usage: How long do you need the asset?
• Ownership Goals: Do you want to eventually own the asset?
• Financial Impact: How will each type of lease affect your financial ratios and balance sheet?
• Tax Implications: What are the tax benefits and drawbacks of each option?
• Risk Tolerance: Are you comfortable with the risks and responsibilities of ownership?

By carefully evaluating these factors and consulting with financial professionals, companies can make informed decisions about leasing that align with their overall business strategy. Whether you opt for the flexibility of an iCapital lease or the long-term benefits of a finance lease, understanding the key differences between these two options is essential for sound financial management.

Conclusion

In conclusion, both iCapital leases and finance leases offer valuable options for businesses seeking to acquire and utilize assets. The key differences lie in ownership, balance sheet impact, lease term, responsibilities, and accounting treatment. By carefully weighing these differences and considering their specific needs, companies can choose the leasing option that best supports their financial objectives and growth strategies. Remember to stay informed about evolving accounting standards and seek professional advice to ensure accurate and compliant lease accounting practices.