What is a Lease?
A lease is an agreement, usually in writing, between the owner of an asset and a lessee.
How Does a Lease Work?
There are many kinds of leases. Some allow the lessee to buy the asset at the end of the lease term, some do not, for example. Regardless, a lease is a legal contract, and violating a lease can result in monetary damages or other remedy by a court. Generally speaking, leases set forth the lease dates, the payments required, and guarantees that the lessor actually owns the asset that he or she is leasing to the lessee.
Accounting for leases can be complicated. There are two general types: operating leases and capital leases. An operating lease is simply a lease on an asset that does not give the lessee rights similar to those of an owner of the asset. Generally, lease payments made under a capital lease go on the income statement and thus reduce profits.
A capital lease is the opposite—it gives the lessee rights similar to those of an owner of the asset. Generally, lease payments made under a capital lease are recorded on the balance sheet and thus do not reduce profits.
GAAP rules state that to determine whether the lease is an operating lease, the lease must not have any of these characteristics:
1. The life of the lease must not be longer than 75% of the life of the asset.
2. The lessor cannot transfer ownership of the asset to the lessee at the end of the lease term.
3. There cannot be an option to purchase the asset at a 'bargain price' at the end of the lease term.
4. The present value of the lease payments cannot exceed 90% of the fair market value of the asset.
Why Does a Lease Matter?
Leases can be for a variety of assets, though real estate often comes to mind first. For example, let's say John Doe owns a house on Main Street. He does not live in the house; he decides to lease it to Jane Smith. John continues to be the owner of the house, but Jane agrees to pay John $800 a month in return for letting her live there for a year. They type up a lease, which sets forth the exact dates Jane can live in the home, what improvements or changes Jane is allowed to make to the home, and what happens if Jane damages the home.
Leases can also be for cars, manufacturing equipment, office space, photocopiers, musical instruments, solar panels, or virtually any other asset. Generally, leases are handy when one party has the capital to purchase the asset and another party does not have the capital to do so but would like access to the asset.