Closed-End Leasing: Evaluating the Options for Fleets

Closed-End Leasing

Evaluating the Options for Fleets

IntroductionCompanies with fleet vehicles have two basicleasing options to consider: an open-endTerminal Rental Adjustment Clause (TRAC)lease, or a closed-end lease solution. Thereare a number of factors that significantlyimpact your company's decision to choose onelease type over the other. Fluctuating marketconditions, such as used vehicle prices andinterest rates, for example, in addition to yourcompany's cash flow goals, could impact yourdecision. For these reasons, it is important tounderstand which lease solution is best suitedto meet your company's needs.

Open vs. Closed - What is theDifference?One of the first steps in selecting the rightlease option for your company is better under-standing the two options that are available.The comparisons below are based on U.S.General Accepted Accounting Principles(GAAP).

An open-end lease, or finance lease, is oneoption that gives the lessee flexibility with theservice life of its fleet vehicles. Although ashort minimum lease term is required, thelessee may terminate the lease at any timewithout a penalty and assume completeeconomic ownership of the vehicle. Thismeans the lessee assumes the depreciationrisk of the vehicle, or the difference between"vehicle sale proceeds" and "book value."The difference between the selling price ofthe vehicle and its book value will determinewhether a financial loss or gain is passed onto the lessee. Under an open-end lease, thelessee also has the option to apply a fixed orvariable interest rate for its fleet's lease term.

Conversely, under a closed-end leasesolution, the lease term for the lessee's

vehicles is fixed - usually 12 to 48 months.Mileage restrictions and wear-and-tear expec-tations are also established at the onset ofthe lease. These criteria help in determiningthe vehicle's condition at lease-end, whichaids in the vehicle resale process. At the endof the fixed lease term, the lessee has no further financial obligations if all mileage andwear-and-tear expectations are met. In addition, the lessor bears any financial gainor loss from the sale of the used vehicle.

If preset criteria such as mileage and wear-and-tear are not met, the lessee isresponsible for paying the lessor a potentialovermileage or unfair wear-and-tear charge.Some lessors, however, offer companies theoption to evaluate their vehicles during certain intervals of the lease term. If itappears that their vehicles are over or underthe predetermined mileage allowance, pay-ments may be adjusted accordingly. Thisprocess, called recalculation, allows pay-ments to be adjusted to more accuratelyreflect actual vehicle usage and prevents thelessee from incurring excess mileage penal-ties at the end of the lease term.

Closed-End Leasing - Is it the RightDecision for My Company?Does a closed-end solution make sense foryour company? There are a number of factorsthat could impact your decision.

One such factor is vehicle depreciation. Asmanufacturers introduce new and improvedproducts to the marketplace, and the usedvehicle market continues to fluctuate, the risksassociated with vehicle resale are promptingmany companies to consider a closed-endlease option. Under a closed-end lease, thelessor determines the vehicle depreciationfactor and is responsible for any gain or loss on

the sale of the fleet vehicle. By putting thedepreciation risk on the lessor, companies canfree themselves from the worry and uncertaintyof vehicle resale at the end of the lease period.

However, if your company wants the option toselect the depreciation factor and bear therisks associated with vehicle resale, an open-end lease type might be the most appropriatesolution. One factor to consider is the risk ofunder-depreciating your assets. To managecash flow, many companies select depreciationrates that are unrealistic under open-endleases in order to create small monthlypayments. This often results in significantlosses when vehicles are terminated and soldat auction. Closed-end leases aim to match payments with actual usage while protectingagainst residual losses.

Your fleet's average mileage is another factorthat could impact your lease decision. If yourfleet's annual mileage fluctuates in an incon-sistent manner, making mileage a hard factorto predict, closed-end leases bringpredictability to your fleet. In addition, closed-end leases provide budgeted, fixed paymentsthat can bring more stability to your fleets'financial cost structure. Most lessors offer awide variety of terms and mileage for closed-end leases, which help you better alignexpenses with actual vehicle usage.

Another factor to consider is the overall treat-ment of your fleet vehicles. Whether youchoose an open-end or closed-end lease,vehicle treatment can have a significant effecton your overall cost of ownership.

Under a closed-end lease, expectations forvehicle wear-and-tear are set upfront andagreed upon by the lessor and lessee. Thisallows companies to educate their drivers on

proper vehicle treatment before charges areincurred at the time of vehicle termination.Under open-end leases, unfair wear-and-tearexpectations still exist, however the marketdetermines the "charge" the lessee receives atauction. This means that vehicle wear-and-tearthat is outside the scope of what is considerednormal to the market, will result in a penaltyagainst the vehicle's value at resale.

In addition, economic conditions and currentworld events are significantly influencing theway companies spend their money. The pressure to do more for less and cut costswherever possible are tightening corporatebudgets around the world. If your companyprefers to know upfront the total lease cost pervehicle, a closed-end lease might be the rightsolution.

Interest rates may also impact your company'sleasing decision. Under an open-end lease,companies have the option to choose a fixed orvariable interest rate. Closed-end leases, however, usually apply a fixed interest rate forthe fleet's lease term. Market conditions and fluctuating interest rates can greatly influenceyour decision to choose one lease type overthe other.

For many international companies in the UnitedStates, International Financial ReportingStandards (IFRS) are pushing them to quicklyconsider a new fleet leasing option. UnderIFRS, companies listed on the European Unionstock exchanges are required to report theirfinancial information under a new set ofaccounting standards. This new requirement ismaking the decision to move to a closed-endsolution an easy one for many companiesaffected by IFRS.

International Accounting Standard (IAS) 17, the

applicable standard for leases, determineswhether a lease is accounted for on or offbalance sheet. For many companies, bringingassets back on to the balance sheet could havea significant financial impact on their business.Introducing a closed-end lease solution to yourcompany could not only help your companycomply with the IFRS regulations, it may beinstrumental in helping your company meetyour financial goals. Contact LeasePlan todayif you would like more information on the effectof IFRS on accounting for fleet assets.

ConclusionAfter understanding the differences betweenopen-and closed-end leases, your companyshould evaluate how each lease type couldaffect your fleet and your business. For companies not affected by IFRS, criticalfactors such as vehicle depreciation, vehiclemileage terms, fluctuating interest rates andcash flow expectations should be carefullyconsidered before choosing a leasing option

for your fleet. It is also important to rememberthat there are many misconceptions aboutopen-and closed-end leasing and what you canexpect under each lease type. There are benefits to each lease, and fully understandingyour company's financial goals will help indetermining which option is right for your company.

For more information on your fleet leasingoptions, please contact LeasePlan USA at1-800-457-8721.

Closed-End Leasing: Evaluating the Options for Fleets

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