Tuesday, January 07, 2014
On-balance sheet funding: time to look again
Contract hire is the UK’s number one fleet funding mechanism, but forthcoming changes to lease accounting rules mean that it will join all other financial options in being on-balance sheet.
A conservative estimate suggests that at least 60% of businesses fund their vehicles via contract hire – exact numbers are not available – with possibly no more than a third opting to outright purchase.
The remainder choose to finance lease, contract purchase, lease purchase, hire purchase or utilise overdraft facilities and loans.
With the exception of contract hire, all other vehicle funding routes require companies to report exposure on their balance sheets at the end of their financial year, thus effectively publishing a snapshot of their well-being.
Presently, publicly-listed companies must also reveal any operating lease (contract hire) outstanding liabilities in a note to accounts within their annual report.
That will change if the proposed accounting standards are adopted, which is expected to be in the second half of 2014.
The BVRLA has been consistently robust in its view that including leased items on companies’ balance sheets does not erode the ‘commercial benefits’ of leasing; it highlights protection from residual value volatility and business capital being freely available and not tied up in buying vehicles.
Below we highlight the main forms of current on balance sheet funding.
Outright purchase
Historically, outright purchase was comfortably the most popular fleet funding method, but over the past 20 years it has been overtaken by contract hire.
Today, fleets that purchase vehicles outright are largely small privately-owned business, cash-rich organisations, or do so for a variety of reasons often due to their uniqueness as a business.
Reasons that organisations buy their vehicles include:
- Tradition. It has always been company policy and gives full control as to how vehicles are managed and when they are sold.
- A belief that paying a third party to provide vehicles is more costly than doing so independently.
- The ability to source funds at a lower interest rate than leasing companies.
- Being a cash-rich business.
Investing money in a depreciating asset can be viewed as a disadvantage when the capital could be used to fund other areas of the business.
A company that buys its own cars and vans is also subject to the volatility of the used market when it decides to sell.
Businesses cannot recover VAT on company cars they buy, assuming there is an element of private use, but capital allowances can be deducted when calculating corporation tax liability.
Contract purchase
Contract purchase enables companies to take advantage of the benefits of both ownership and contract hire.
As it is legally a conditional sale agreement under which a company is buying the vehicle, it is treated as on-balance sheet.
Contract purchase enables a company to buy a vehicle on deferred purchase terms by paying fixed monthly instalments over an agreed contract period.
Full ownership of the vehicle is completed with a lump sum, or balloon payment, at the end of the contract based on its residual value.
However, the company can also return the vehicle to the supplier at the end of the contract term.
Businesses choosing to return the vehicle are protected from the residual value risk as the supplier is obliged to buy back the vehicle for a pre-agreed fixed price.
Consequently, the supplier is gambling on whether the company will sell the vehicle back to them and the market price.
Contract purchase offers predictable monthly costs as payment terms are fixed up-front and include maintenance.
It can be an attractive option for companies which are unable to obtain VAT relief due to their exemption status – for example banks, building societies and professional services organisations – as VAT is not due on the monthly rental and is chargeable only on the maintenance element of the monthly charge.
Nevertheless, it is estimated that contract purchase represents less than 5% of fleet market finance and therefore remains a niche product.
Finance lease
Finance lease sees a company take the residual value risk on a vehicle and therefore is on-balance sheet.
Companies choosing finance lease can opt to structure their rental payments in two ways:
- A fully amortised finance lease means the entire capital value of the vehicle is repaid in equal monthly amounts over the contract period with all proceeds from the sale of the vehicle being repaid by the lessor as a rental rebate.
- Alternatively, finance leases can include a balloon payment at the end of the lease period. The balloon payment will usually be equal to the estimated residual value of the vehicle. As a result, monthly rental payments will be lower.
A maintenance package can also be added.
Experts say that finance lease has few, if any, advantages over contract hire.
However, fleets choosing this option believe that having responsibility for residual values enables them to benefit from strong in-life management of vehicle condition, and also means they do not risk costly end-of-contract charges from leasing companies.
Around 4% of the Fleet News Fleet200 opt for finance lease for all or part of their vehicle funding needs.
VAT treatment of finance leases is similar to that for contract hire with 50% of the VAT on the capital element of the lease recoverable.
Hire purchase
Hire purchase is an agreement with the option to purchase at the end of the contract period.
The company hiring the vehicle has all the risks and rewards of ownership, including residual value, so the car or van must be shown as an asset on the balance sheet.
Although there is no contractual obligation to take ownership of the vehicle at the end of the agreement, it is usual for ownership to occur at the end of the agreement for a nominal amount.
As a result, for corporation tax purposes, the vehicle is deemed to belong to the hirer at the outset of the agreement and therefore capital allowances also apply.
Lease purchase
Similar to hire purchase and therefore a method of deferred purchase with a balloon payment to secure ownership of the vehicle at the end of the contract. Also on-balance sheet.
The inclusion of the balloon payment means the monthly charges will be lower than with a hire purchase agreement.
The balloon payment will be calculated as equivalent to the value of the vehicle at the end of the lease period.
Therefore, the company, if it chooses to sell the vehicle, should be able to cover the cost of the balloon payment from the sale proceeds.
Alternatively, the company could continue to operate the vehicle as the owner.
On or off the balance sheet: does it matter?
“Any company worth its salt is reporting a corresponding liability within its accounts. I don’t see that whether contract hire is on- or off-balance sheet makes any difference to its viability.”
Adrian Harris, fleet manager, Pertemps
“The benefits of contract hire, notably no requirement for capital expenditure, outweigh any burden of on-balance sheet reporting from an accounting viewpoint.”
Tristan Campbell, fleet advisor, Chivas Brothers
“Being off-balance sheet is not a key driver when fleets come to choose contract hire. Publicly-listed companies already provide a note to accounts about their leased assets.”
Gerry Keaney, chief executive, BVRLA
“I cannot recall any organisation choosing contract hire because it is off-balance sheet – it is not the principal reason for choosing contract hire. The reason for choosing contract hire is because it is a smooth and efficient way to run a fleet.”
Nick Hardy, group marketing director, Ogilvie Fleet
“When vehicles are included on a company’s balance sheet, bankers will adjust the organisation’s credit score accordingly. That will impact on a company’s risk position and ultimately the amount of money it can borrow.”
Alastair Kendrick, tax director, MacIntyre Hudson
“The changes will not cause businesses which provide a fleet of cars via contract hire to switch from this form of funding because of the additional benefits that it brings, such as fixed budget costs.”
Dan Rees, senior manager – Deloitte Car Consulting, Deloitte
“Even if some companies do consider moving away from contract hire, I think they will still do business with their contract hire companies in order to retain access to the discounts and administration benefits that those organisations deliver.”
Colin Tourick, management consultant
“On- or off-balance sheet has never been highlighted as a prime reason for choosing a particular funding route outside of a handful of organisations that have specific individual reasons for having vehicles off balance sheet.”
David Rawlings, director, BCF Wessex Consultants
Case study: BCA
Auction giant BCA operates an outright purchase policy for its fleet of vehicles which results in the assets being included on the company’s balance sheet.
The operation of the policy, says BCA, is consistent with both its methodology for sourcing vehicles and how the company deals with those vehicles for accounting purposes.
As a vehicle remarketing company, BCA is uniquely placed to be able to source vehicles from its vendors via its own auctions.
Marie Jarrold, who is in charge of the 470-strong fleet, says financial savings are created through the purchase of ‘nearly-new’ vehicles up to one-year-old and ideally with a maximum of 10,000 miles on the clock.
Where the sourcing of vehicles is not possible through auction or vendor contact, then purchase through dealerships or through vendor relationships is undertaken.
Sourcing low-mileage nearly-new vehicles enables BCA to leverage the dual benefit of remaining manufacturers’ warranties, while avoiding heavier first year depreciation.
BCA operates both a standard benefit-in-kind vehicle scheme and a car ownership scheme with drivers having the option to purchase their vehicle; specific employees are eligible.
Outright purchase allows flexibility over which of the schemes is operated for an individual driver and gives flexibility around the chopping and changing of vehicles within the fleet. BCA is also able to dispose of vehicles through its own auction network.
Jarrold says: “Outright purchase therefore provides BCA with more flexibility, and leverages the company’s industry position to keep fleet costs controlled.”
Case study: Peter Lole & Co
Small fleets have the flexibility to choose the optimum funding avenue by reacting to value for money deals that may be on offer from franchised dealers and contract hire and leasing companies.
That’s the view of Len Benson, chairman of ACFO’s London West region and in charge of a nine-strong fleet at marine and commercial insurance broker Peter Lole & Co.
He is responsible for the company’s commercial fleet and motor insurance business, and his relationship with clients means that occasionally they have ‘spare’ cars for sale due to an employee leaving and an inability to reallocate.
That means Peter Lole & Co from time-to-time buys used cars for its fleet if vehicle age and circumstances allow.
Currently the user-chooser fleet includes four Hyundais “because the local franchise was able to put together a good deal”, explains Benson. However, the company’s fleet also includes cars on contract hire.
“Being a small fleet we have the flexibility to make decisions on how we fund a car each time one is required,” he says.
“We don’t have a particular policy that dictates we should go down one funding route.
“Drivers are concerned about the P11D value of the car and we are also concerned about emission levels.
“Contract hire is off-balance sheet currently and gives us fixed cost motoring, which we like but we don’t rule out outright purchase.
“We choose what is financially right for the business when a vehicle is required depending what is available. There are some good offers from our local dealers, as well as leasing companies and the opportunity to buy used or nearly-new.”
Case study: DFS
High street furniture retailer DFS moved to contract purchase two years ago as a consequence of switching its car fleet from an in-house management operation to an outsource arrangement with Hitachi Capital Vehicle Solutions.
Privately-owned DFS, which has a 420-strong car fleet, reports its profitability in EBITDA (earnings before interest, income taxes, depreciation and amortisation) and therefore purchasing vehicles is the most financially astute accounting mechanism for the business.
Opting for contract hire would impact on the company’s profitability with costs hitting the bottom line.
Andrew Stephenson, the company’s HR director, says: “Having decided to outsource our fleet and become more efficient by basing choice on wholelife costs and introducing maintenance management, it was then a case of deciding how to fund the vehicles.
“We had always bought our cars so it made sense to continue to use a form of purchase for accounting consistency in terms of the company balance sheet and without any impact on profitability.”
The core fleet is a based on a triple-badge Audi, BMW and Vauxhall option for drivers with senior management having an open choice.
Cars are operated on a four-year/100,000-mile cycle with Hitachi disposing of the vehicles at the end of their contracts and targeted on achieving pre-set residual values.
Case study: Travis Perkins
The Travis Perkins Group buys more than 1,500 company cars via its own internal leasing company and leases them to the business net of any profit.
Fleet director Graham Bellman calculates that the group derives a 10% cost saving compared with external leasing, although the company continuously reviews all options.
Available finance coupled with vehicle reallocation and replacement cycle flexibility are key reasons behind the decision with core Ford and Volkswagen models typically run over four years/100,000 miles and executive grade cars over five years/120,000 miles.
Highlighting that there is a role for contract hire within the Travis Perkins Group business, the company continues to contract hire a
subsidiary’s fleet of approximately 800 cars via two providers, although replacement cycles have extended from 43 months/60,000 miles to 48 months/80,000 miles since acquisition.
subsidiary’s fleet of approximately 800 cars via two providers, although replacement cycles have extended from 43 months/60,000 miles to 48 months/80,000 miles since acquisition.
Bellman says: “There is a place for leasing companies, but for the bulk of our fleet we use our own funds.”
DATED: 07.01.2014
FEED: PTL/FN
