If you have ever bought a car you know you have two options: lease or buy. In fact, for many assets that businesses use such as buildings, machinery and other equipment, businesses have the same choice between leasing or buying. Although the title of an asset will not transfer to the acquiring business under a lease, the business will have exclusive use of the asset for as long as the lease term is. If the cost of acquiring an asset by lease is less than the cost of purchasing the asset outright, it probably makes sense that the business lease, rather than buy.
Leases have become increasingly popular since the Second World War. Before, companies that wished to purchase assets had to finance the assets with cash, a bank loan, or raising new equity. That means that even the most stable asset investments were probably financed at an interest rate that reflected the over-all risk of the business. Demand for cheaper financing opened the doors for a large number of leasing companies, including banks, to start offering leasing services. Leasing options also make it easier for small businesses to acquire large assets without onerous initial cash outlays. Companies may offer the leasing service in house, such as GM Financing, or they may sell the asset to a leasing company who is then responsible for administrating the lease for the business who wanted the asset.
Lessee: The party who acquires use of the asset and must make lease payments. Leasing is a financing decision for the lessee.
Lessor: The party who owns the asset and receives the lease payments in exchange for its use. Leasing is an investment decision for the lessor.
Operating Lease: A lease whose term is less than the useful life of the asset, whose total payments are less than the initial cost of the asset, where maintenance and insurance for the asset are negotiable, and where the lease is often cancellable. Operating leases are only disclosed in the notes of the financial statements. This is called off-balance sheet financing.
Financial (or Capital) Lease: A lease whose term is generally the life of the fixed asset, whose total payments are more than the initial cost of the asset, where the lessee is responsible for maintenance and insurance and where the lease is non-cancellable. The present value of the payments of a financial lease are recorded as an asset and a liability on the balance sheet.
According to the IRS, leases are classified as either guideline or nonguideline. For a guideline lease the entire lease payment is tax-deductible. For a non-guideline lease, only the imputed interest rate is deductible.
When purchasing large assets, many wondering whether they should lease or buy the asset outright. There are advantages and disadvantages of both. An advantage to buying an asset, let's say, a car for example, is that you are the owner of the car. Because you are the owner of the car, you are responsible for paying the entire price upfront (assuming there is no down payment). If you do not have sufficient cash to pay for the car, you have to take out a loan, which will acquire interest. In the case of a lease, you will only borrow the amount the car will depreciate over the agreed term of the lease. With a lease, you are not as liable for the asset. Let's say after the lease term, you want a new model of car. You can easily sign a new lease contract and get the new car. With buying a car, you are responsible for selling it if you want to purchase another car.