Lease Transactions: An Overview

Leasing is one way for companies of all sizes to have the use of assets. The entity that is providing the asset is called the lessor. The entity receiving the asset is called the lessee. Most capital assets, from vehicles to computers to machinery, can be leased.

Leases fall into two major categories: operating and capital. As GAAP can vary from country to country, you should discuss leasing with your accountant. This session presents us and Canadian GAAP with respect to leases.

An operating lease simply reflects the fact that you are renting the use of an asset. It is usually a short-term lease that can be canceled. The lessee does not have the risks and rewards of ownership. If the asset breaks down, the lessor has to fix it, not the lessee. If it increases in value, the lessor gets the benefit, not the lessee.

Most office space rentals are structured this way. You rent the office space for the term of the lease, then you have to leave. The space doesn't belong to you.

Most vehicle leases are also structured this way. You are basically "renting" the vehicle for the term of the lease, then you either have to buy it at its fair market value or give it back. You do not own it.

A capital lease, however, represents a method of financing an asset, similar to a loan. The lessee makes payments for the lease period, after which time, the lessee either owns the asset outright or can buy it for a nominal amount. During the lease period, the lessee must insure the asset and finance any repairs or maintenance required. The lessee therefore has taken on the risks and rewards of ownership.

There are three criteria that are used to determine if a lease counts as a capital lease. Only one of these criteria must be met:

1. The lease term is equal to 75 percent or more of the estimated useful life of the asset.

2. The present value of the lease payments is equal to 90 percent or more of the value of the asset at the beginning of the lease.

3. The lease transfers ownership of the asset to the lessee at the end of the lease term or allows the lessee to purchase the asset at a bargain price (referred to as a bargain purchase option).