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LEASES
LEASES
A lease is a contract that gives a lessee (user) the right to control the use of an asset for a period of time. The lessee pays the lessor (owner) for that right, typically with a series of payments made over the lease term.
Accounting by the lessee
Accounting by the lessee
Why lease?
Why lease?
1. The Lessee needs less cash than when s/he buys.
When an asset is purchased, the purchaser must pay: (a) loan origination fees, (b) closing costs, (c) brokerage fees, and (d) taxes. This isn't the case in a lease situation. A lease can start, simply, with the first monthly/yearly lease payment.
2. Lease payments are often lower than loan payments.
Lease payments are tied only to the portion of an asset's fair value that is expected to decline over the lease period. For example, a $300,000 building could be leased for 3 years. The useful life of the building could be 30 years. Each year the building will decline in value by $10,000 ($300,000 ÷ 30 years). The lease payments, then, would be calculated using $30,000 ($10,000 of depreciation per year × 3 years) as opposed to the asset's full value $300,000.
3. Getting rid of the asset is easier and costs less.
If you rent an apartment and later decide you want to move, you simply move out and pay whatever remaining rental payments are left. If you own a house, on the other hand, and later decide to move, you often need to hire a real estate agent (who will charge a commission for selling the house), pay taxes, and make any necessary repairs.
4. Could protect against the risk of declining asset values.
Many assets decline in value over time (depreciation). If you lease an asset, you don't care if the asset declines in value (it's not your asset).
5. Could offer tax advantages.
Companies can reduce taxable income by deducting depreciation expense. A young company, who hasn't made much profit yet, cannot take advantage of the depreciation deduction (taxable income is already less than $0). But, it can negotiate a favorable lease price by allowing a profitable lessor to retain ownership of an asset. The lessor will get a tax benefit through a depreciation deduction and could pass the savings along to the lessee.
Lease classification
Lease classification
A finance-lease is a lease in which the lessor (owner of an asset) transfers control of an asset to the lessee (user of an asset). An operating lease, on the other hand, results in the fundamental rights and responsibilities of ownership being retained by the lessor; the lessee gets to use the asset on a temporary basis.
Note: From the lessor's perspective, a finance-lease is referred to as a sales-type lease.
Difficulties in classifying leases in practice
Difficulties in classifying leases in practice
What if the terms of the contract do NOT transfer ownership from the lessor to the lessee, but the lease term is for 7 years of the asset's 8 year useful life? Is this effectively a sale of an asset by the lessor to the lessee?
What if the terms of the lease specify that ownership is transferred to from the lessor to the lessee IF certain conditions are met during the lease term? Is this a "sales-type" lease or an "operating lease"?
What if the total payments to be paid over the lease term are greater than the asset's value had it been sold? Is this a "sales-type" lease or an "operating lease"?
Classification criteria: When does a finance lease exist?
Classification criteria: When does a finance lease exist?
5 criteria; if any single item is true, then lease is a finance/sales-type lease
The agreement specifies that ownership of the asset transfers to the lessee.
The agreement contains a purchase option that the lessee is reasonably certain to exercise.
The lease term is for the "major part" of the remaining economic life of the underlying asset.
The present value of the total of the lease payments equals or exceeds "substantially all" (for practical purposes, more than 90%) of the fair value of the underlying asset.
The underlying asset is of such a specialized nature (i.e., a custom asset) that it is expected to have no alternative use to the lessor at the end of the lease term.
Example: Accounting for a finance lease
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