When an asset is acquired with financing provided by a lessor, the transaction is called leasing. When the lessee enters into a leasing arrangement, it pays a fixed periodic fee to the lessor. This fee is essentially comprised of the return of capital to the lessor, plus an interest component. The lessor may also charge the lessee for other fees incurred to acquire and hold the underlying asset, such as personal property taxes.
There are two general types of lease, which are:
- Operating lease. An operating lease is a financing arrangement under which the lessor officially owns the leased asset and records the asset in its financial records. The lessor therefore records the depreciation expense associated with the asset. The lessee only records a lease expense in each period, in the amount of the payment made to the lessor. The lessee does not record the existence of an asset. This type of lease is more likely to span a period that is less than the full life of the asset, and the lessee is not offered a buyout clause at the end of the contract.
- Capital lease. The roles of the two parties are reversed under a capital lease. Under this arrangement, the lessee records the asset in its records, and recognizes depreciation expense. The lessee splits apart all payments made into their interest and principal components, and records each element separately. In essence, the arrangement is treated as a loan that is used by the lessee to buy the asset.
There are several ways to reduce the cost of leasing arrangements. One is to acquire a number of assets under the umbrella of a single lease arrangement, so that the lease-specific costs are reduced. Another alternative is to take the same approach for existing leases, paying them off and pooling them under a single master lease; doing so can reduce the aggregate financing cost.
Leasing is an excellent financing alternative for organizations that only want to set aside a few assets as collateral, thereby leaving all other assets for use as collateral for other types of loans, such as a corporate line of credit. A lease can be a viable alternative even for a business that is not in the best financial condition, since the lessor retains ownership of the leased asset, and so can reclaim it if payments are not made in a timely manner. Further, a lessor is unlikely to impose covenants on the financial operations of the business as a whole.
Despite its advantages, there are some problems with leasing. In particular, a lessor can obfuscate the lease rate being paid, resulting in high interest rates. Also, the typical lease agreement requires that all payments be made through the life of the lease; there may be no option for early payment.