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Lease Agreements

Lease Agreements

A lease agreement is a legal contract between two parties for the usage of an asset or property over a set period of time in exchange for rent payments. The owner of the asset or property allows another party to use the asset or property for payments. Often a lease agreement includes an option to buy the leased asset or simply transfers ownerships to the lessee at the conclusion of the lease.

Parties in a Lease Agreement

The party that owns the asset is the lessor, or the landlord. The party that pays for using the asset is the lessee, or the tenant. The lessee is the party that pays for the usage of the property. The lessor is the party that owns the property and collects rent payments from the lessee.

Advantages of Leasing

A lease agreement can benefit the lessee by giving them access to and usage of an asset they might not be able to afford. For example, if a company is starting up and does not have the capital to purchase expensive equipment or machinery, the company would be better off leasing the equipment or machinery for monthly payments.

A lease agreement can benefit a lessor by turning an unused asset into a source of income. If the lessor owns a valuable asset but is not making use of it, they would be better off leasing it to another party who can make use of it, and in return receive the rental payments.

Types of Lease Agreement

In accounting, there are several types of lease agreements. The conditions of the lease agreement determine how the transaction is recorded in the company’s financial statements. The types of lease include capital lease, operating lease, and sale and leaseback.

In a capital lease, also called a financial lease, the lessee acquires all the benefits and responsibilities of ownership of the property. They must record the lease on their balance sheet as an asset with a corresponding liability.

An operating lease is also called a service lease. The lessor retains all the benefits and responsibilities of ownership. However, the property is not recorded on the lessee’s balance sheet.

Whereas in a sale-and-leaseback agreement, the owner of the property sells it to another party. Then, they immediately lease it back from that party. The owner becomes the lessee and the buyer becomes the lessor. Companies do this to free up cash that may be tied up in an illiquid fixed asset.

Lease Agreements

See Also:
Lessor versus Lessee
Sale and Leaseback
Capital Lease Agreement
Agency Costs
Make-or-Buy Business Decision

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Financing Lease

See Also:
The Dilemma of Financing a Start Up Company
Lease Agreements
Operating Lease
Sale-and-Leaseback
Lease Term

Financing Lease Definition

The financing lease definition, also known as a capital lease, is a method of deferred payment. If the lessee is willing to pay the additional cost of interest, then they can use a financing lease to pay off a capital investment over time rather than all at once. Different from an operating lease, a company who uses a financing lease gains ownership of the item when the lease period is over. Generally, they have to pay a final balloon payment which is less than the fair market value of the item if it was new.

Financing Lease Explanation

A financing lease, explained simply as lease-to-own, has many benefits. First, it allows the interested party to use a deferred payment schedule on a necessary tool. This has been explained above.

Other benefits of a financing lease make it a more attractive option. To begin, the lessee may still gain the benefit of depreciation, thus saving money on taxes. This is a benefit which makes a financing lease more appealing than an operating lease. The cost of this is that a financing lease can only write off the expense of interest payments rather than principal. Insurance premiums, repair costs, and taxes are incurred by the lessee rather than the lessor. Additionally, they claim the risk of ownership on the item.

Another benefit is that this type of lease allows the purchasing party to own the item at the end of the agreement, making the lease an effective investment rather than a cost of doing business. Many financing leases allow the purchasor to receive the item whenever they want by paying off the final principal value in one lump sum.

For a financing lease accounting to run smoothly, a few standards must exist. Ownership of the item at the end of the lease term and purchase choice form the first two. Next, the length of the lease must be 3/4 the economic life of the item. Finally, the lease payments must comprise at least 90% of the cost of the item if it was purchased instead of leasing. These traits make a financing lease a unique tool for a customer who wants a tool, wants to receive vendor financing, wants to gain ownership of the item, and wants flexible terms in all of this.

Financing Lease Example

Devin has created a new soda company. Modeled after the tradition of Italian Sodas, Devin believes the US market would love to try his tasty beverage. He appears to be succeeding from his initial efforts of marketing and selling his product.

Now, Devin must expand his business. To do this, he will need a larger bottling machine. Devin wants the equipment but also wants to reserve the cash he has for expansion. He expects growth but currently, from his planning of company finances, only has so much to spend.

Devin decides on a direct financing lease with the equipment provider. Here, he can have and work towards owning the item as soon as possible. He likes the terms his vendor provides on financing, especially that he can pay off the item if he sees more success than he expected. This is known as a financing lease buyout.

In this agreement, Devin negotiates the total price, interest rate, principal and interest payment schedule, and any associated penalties and fees. Devin is able to find a great deal on the item and completes the contract. He knows that by financing the item he will pay a little more, but overall appreciates his decision. It will help create the success he has envisioned.

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Financing Lease Definition, Financing Lease Explanation, Financing Lease

Financing Lease Definition, Financing Lease Explanation, Financing Lease

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FASB Lease Accounting Changes

See Also:
Capital Lease Agreement
Lease Agreements

FASB Lease Accounting Changes

A change in accounting rules implemented by The Financial Accounting Standards Board (FASB) has led to FASB lease accounting changes. Furthermore, the proposed lease accounting changes will bring a large amount of debt onto the balance sheets of companies that have large operating lease commitments. Going forward, the lease commitment will be recognized as a liability. In addition, the offsetting asset will be a right-to-use for the material being leased.

FASB Lease Accounting Rules

An example of an operating lease would be where a company rents office space. Under the new FASB lease accounting changes, the future lease payment obligations will be on the balance sheet as a liability. The offsetting asset will be an equivalent “right-to-use” entry.

At the end of the contract, the capital lease has an option to purchase the leased asset. In accordance with the new FASB lease accounting rule, the capitalized lease is already required to be carried on a company’s balance sheet as a debt to lease holder and an asset entry for the item being leased. This ruling in effect makes all leases capital leases.

Effective date

The effect of the FASB proposal on lease accounting could be enormous on industries that have large exposure to operating leases, such as real estate companies, etc. Also, a possible effect of the FASB lease accounting proposal would be where companies have to recognize leases on their balance sheet. That changes some loan covenants for debt ratios, etc. The changes became effective after the FASB decision in March 2011.

FASB lease accounting changes

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Capital Lease Agreement

See Also:
Fixed Assets
Current Liabilities
Long Term Debt
Sale and Leaseback
Working Capital
Secured Claim

Capital Lease Agreement

A capital lease is a type of long-term lease agreement. A capital lease is recorded on the lessee’s balance sheet. This type of lease typically spans most of the useful life of the asset. In a capital lease agreement, the lessee, the party receiving the asset, assumes both the risks and benefits of ownership. Also call a capital lease a financial lease or finance lease.


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Capital Lease Treatment

According to GAAP, property leased with a capital lease agreement must be recorded on the lessee’s balance sheet. Record the leased property as an asset with a corresponding liability. Then depreciate the asset. The liability is amortized. Payments of the interest and principal are considered separate expenses on the income statement.

According to GAAP, if a lease agreement meets one or more of the following four criteria, you must treat it as a capital lease.

1. The lease agreement includes a clause stipulating that ownership of the asset automatically transfers to the lessee at the end of the lease.

2. The lease agreement includes a clause stipulating that the lessee can purchase the asset at a discounted price at the end of the lease.

3. The duration of the lease spans at least 75% of the asset’s useful life.

4. The present value of the lease payments is equal to at least 90% of the original value of the asset.

Finance Lease versus Operating Lease

There are two main differences between capital (finance) leases and operating leases.

1. With a capital lease, the lessee must record both a lease asset and a lease liability on their balance sheet. With an operating lease, this is not required.

2. With a capital lease, the lessee assumes both the risks and benefits of owning the asset. With an operating lease, the lessor retains the risks and benefits of owning the asset throughout the duration of the lease.

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capital lease agreement
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