Leasing IT Hardware – An Insider’s Perspective

By Jenny Schuchert, IAITAM

ITAK V7 I2

Leasing IT assets can bring significant financial and operational benefits to an end customer, but only if you follow IAITAM best practices and the advice of your Hardware Asset Manager.  While the operational and logistical issues can be solved by the knowledge, experiences and organizational awareness of the Hardware Asset Manager, the financial benefits require the input of your firm’s Finance or Accounting Department.  Incorrect understanding and, frankly, misinformation about the choices and the legal agreements add to the difficulties and confusion with leasing.  Recently, I met with a recent CHAMP graduate to gain additional insights into leasing.  He has 32 years of experience in sales and business development for leasing companies, working with a broad array of partners.   This collaborative article captures some of the most thought-provoking points from those experiences, plus an update on international rules that are changing lease accounting.

Definitions

The vocabulary of leasing can be difficult to navigate.  The roles are described as lessee (the end customer) and the lessor (the originator of the lease, who lends the money).  A lease is no more than a financial contract.  End user organizations tend to think of a lease only in terms of the equipment that is provided when it is actually just a financial agreement.  This distinction is important to understanding the behavior of a lessor and the lessee’s contractual obligations. For instance, if the equipment doesn’t work, the Hell or High Water clause of the lease contract still requires the lessee to pay the monthly rental. The lessor, even a manufacturer’s in-house (captive) leasing arm, is not responsible for product performance and will demand payment regardless of the circumstances. The lease contract obligates the lessor to buy the products and provide all the benefits of use to the lessee while the lessee is obligated to pay the lessor the agreed upon monthly rental.  Whether the product works as promised or sits idle is inconsequential to a lessee’s obligation to make the monthly payments.

From the other perspective, the lease contract is usually not enforceable until the lessee signs and dates a separate document known as the Certificate of Acceptance (COA).  If a customer signs a lease but cancels prior to shipment or never accepts delivery of the equipment, there usually isn’t much that the lessor can do beyond repossession of the product.  This scenario is why lessors may also request a purchase order as part of the leasing paperwork so that the cancelled lease converts to a sale and protects the investment of the lessor in new equipment.

In most cases, the lessor acquires new equipment to fulfill the lease.  The price paid for the equipment is figured into the calculations for the lease to ensure that the lessor is paid back for the investment within a certain time period.  The term lease rate factor is used by end user organizations to describe the multiplier discount received as additional equipment is leased.  This definition is provided in the IAITAM course materials.  For the lessor, lease rate factor describes the monthly rent charged divided by the total cost per item.  This rate is usually calculated by line item, but it can be applied to the entire lease.  Other pricing tools include universal rate and pricing coefficient.

Why Lease?

In addition to saving money to acquire assets, simplified asset disposal, flexibility for technology refreshes and unexpected growth, leases have been an appealing method to avoid a major one-time capital expense.  However, new global accounting standards are changing that advantage.  In the US, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) have been working jointly to replace lease standards.  The primary objective of the new lease accounting standard is to compel lessees to capitalize operating leases as a Balance Sheet asset.  This eliminates an attractive incentive for lessees who do not want to list IT hardware as a corporate asset.  By January 2014, organizations must move leases on the balance sheet so that by 2015 there is a year of capitalization.

Capitalization of leases is likely to change when and how much organizations lease.  However, avoiding large cash outlays will still be a major reason to continue leasing.  The bigger the deal, the more likely it is that the organization will still lease.  Servers such as those for a SAN farm routinely cost several million dollars and when the outlay is seven figures, financing is an attractive alternative.

Some expect leasing to drop off during budget-crunch times.  That is simply not the case.   Lessors with access to cash, such as captives, enjoyed far more success in 2009 than the general economy.  Leasing allowed customers to preserve their own cash and/or bank credit lines.   Economic uncertainty encouraged corporate boards to offset productivity losses from personnel lay-offs by enhancing IT capabilities with upgraded IT hardware and software.

Lease Mine Fields

The most costly problems for customers usually happen at the beginning or at the end of the lease.  Legal language, uninformed end users and lessors making significant money from confusion are a recipe for cost escalation.

Lease Commencement

At the start of a lease, interim rent is a huge source of aggravation.  Lease contracts typically define the lease commencement date as the first day of the month AFTER the products have been delivered and accepted for use by the end customer.  The acceptance date is determined by the lessee signing and dating the lease Certificate of Acceptance.  Interim rent is the daily charge for using the equipment from the COA date to the Lease Commencement Date.  This can cause a noticeable increase in the total cash payments.  A 36-month lease, for example, with an interim rent option can actually cost nearly a full month more than budgeted.  If you sign and date the COA on the second day of the month, you actually pay 36 months of lease term plus 29 days of interim or daily rent.  Conversely, if you sign the COA on the 30th of the month, you only pay one day of interim rent.   If the delivery, installation, and acceptance are not under your control, negotiate a first of the month billing structure from the lessor because it eliminates interim rent.

The first invoice received from your lessor can also cause significant confusion and aggravation.   If your lessor generates their invoices via a batch run (which is typical for large lessors), and your lease paperwork is processed after the batch run, your first invoice can be hard to interpret.  Your invoice could include 2-3 months of payments and interim rent if applicable.  The invoiced amount may be absolutely correct, but you will need to true-up the payments.  The first invoice can escalate to difficult meetings, with the end customer’s Accounts Payable personnel concerned that they are being ripped off.  The solution is to warn your Accounts Payable department ahead of time and confirm in writing with the lessor during the negotiations when lease payment invoices are generated.

Matching Lease to Actual Use

When Fair Market Value (FMV) or long term rental leases are renewed, the big winner is the lessor, not the end customer.   Lease renewals or end of term purchases can cost the lessee 25% or more compared to a conventional purchase agreement.   A convenient rule of thumb is based on the projected useful life of the hardware.  If the product will stay in the data center for 42 months or more, the end customer should ask the accounting and taxation personnel to compare a purchase or capital lease (Buck out) option to an FMV lease (Lease/Purchase Analysis).   Depreciation, disposal expertise, and projected lifetime total cost of ownership are just some of the considerations a Hardware Asset Manager has to discuss with both Finance and IT personnel when deciding whether to purchase or lease.

Major acquisitions in the seven figures such as servers are routinely leased but lose their cost advantage when the lease is upgraded.  It is not uncommon to see a lease contract for a server that has been upgraded three times and to have three contractual line items; two representing model types long gone from the organization.  When hardware is upgraded without changing the asset’s serial number, the lessor’s accounting rules may dictate fully disclosing on the lease contract all the interim model upgrades to the final product now on the computer room floor.  Explaining to your executives unfamiliar with a lessor’s billing practices why they are still see monthly charges for equipment that is no longer on the floor can be an unpleasant experience.

During the lease creation, the Hardware Asset Manager should coordinate the needs of both the IT and finance personnel.  While an FMV lease is the cheapest method to acquire hardware over the initial lease term (usually 36 months), it quickly loses its cost advantage with each succeeding month.  Conversely, a capital lease or purchase is more cost effective for long-lived products, but if the hardware does not stay in productive use as long as predicted, it creates a tax, accounting, and cost-benefit matching problem for the accounting staff.

Captive Lessor Advantages

If the end customer works directly with the manufacturer for hardware acquisitions, definitely include the manufacturer’s captive lessor in the RFP.  Most manufacturers subsidize the internal cost transfer between manufacturing and financing to make their leasing proposals more attractive.  Their incentive is to ensure total control of the asset for future upgrades or replacement and eliminate competitive upgrade alternatives.  This internal discounting is only available via captive financing and reduces the end customer’s monthly rental.  Captive lessor rates compete favorably with bank rates and are fixed over the lease term instead of a bank’s floating rate line of credit.

Notifications

The end of lease notice period for termination is a HUGE money maker for lessors and another bone of contention for lessees.  When pricing a competitive lease transaction, a lessor commonly evaluates the ITAM expertise of the lessee.  If confronted with a pricing battle, a lessor may charge less per month to win the award if the lessee is known to have poor ITAM practices.  A history of late end of lease termination notices is a good indication the lessee has poor internal decision making or inter-department communication.  Some end customers often do not see the need for notifications or are dissatisfied that the step is necessary.  Regardless of the reason, missed termination notice deadlines are very profitable for the lessor, especially if the lessor has a rolling six month notification window so that one day past the deadline turns into six more months of payments.  The solution is to be more strategic.  It is never too early to submit your lease termination notice.  Always submit the notice in writing even if you are already negotiating with your lease sales person about renewals.  Lease termination notices are a lessee’s contractual obligation and must be submitted on time to avoid extra expense.

Granular versus All

When negotiating your end of lease options, consider whether the end of lease decision is granular (by line item) or all-or-nothing.   The lack of granularity can become a huge problem if you sign a large lease deal and later want to mix and match which products you want to keep or return.   A common example of this situation is when a large number of laptops or desktops are leased.

While we all know how to define Fair Market Value, how it applies to an end of lease option is not so straight forward.  Does the lessor charge wholesale FMV, retail FMV, or in-place FMV?  Have the lessor’s legal department define FMV upfront and in writing as it pertains to the end of lease options, how and when the lessor calculates the end of lease FMV, and your dispute/arbitration options.  Lessors may try to charge in-place FMV, which is a premium that considers a lessee’s savings from avoiding the cost of de-installing, packing, shipping, and system disruption.  FMV, as defined, is an arm’s length transaction between a willing buyer and a willing seller where neither party is compelled to buy or sell.  Charging an in-place premium recognizes a lessee’s compulsion to buy to take advantage of his perceived savings.

ITAM Program Instrumental to Leasing

Leasing is business activity that allows a Hardware Asset Manager to illustrate and employ the value of expert IAITAM practices:

  • Conduct a lease versus purchase analysis to be done for every asset class or project implementation. This analysis sets proper expectations for the hardware from all aspects of your enterprise and includes:
  •  Projected life expectancy for the products
  •  Lifetime total cost of ownership
  •  Tax benefit comparison of depreciation versus deducting the lease cost
  •  Aligning costs to benefits
  •  Budgeting ease
  •  Cost of capital considerations
  •  Competing cash needs of the corporation
  •  Disposal obligations and capabilities
  •  Redeployment potential for the hardware
  • Examine the quality of the ITAM internal systems, controls, and expertise to determine with the organization is capable of effectively leasing or whether the poor Asset Management practices create exposure that can be
  • Determine if there is a reliable lease end notification process so that technology refresh/upgrade evaluations are completed prior to the notification period end
  • Evaluate whether contract advantages and options are recognized and used such as:
  •  Is interim rent an option and a good idea?
  •  Would the finance department prefer a non-standard payment schedule (e.g. quarterly payments, uneven payments, deferrals), payments be due at the beginning of the month or payments due at the end of the month?
  •  When financing software or services, are all hardware, licenses, and maintenance periods coordinated to have the same end date (made co-terminus)?
  •  If a rent deferral is offered, is the service contract extended to cover the entire lease term?
  •  Is the manufacturer’s warranty period considered when calculating extended service maintenance coverage for the entire lease term or is there double payment for maintenance coverage?

Leasing your IT products can deliver substantial benefits or cause substantial pain to your organization.  The difference is usually the organization’s level of Hardware Asset Management expertise.

About Jenny Schuchert

Jenny Schuchert is the Content Director for IAITAM