A lease is a contract between the owner of an asset, the lessor and another party seeking use of the assets — the lessee. Through the lease, the lessor grants the right to use the asset to the lessee. The right to use the asset could be a long period, such as 20 years, or a much shorter period such as a month. In exchange for the right to use the asset, the lessee makes periodic lease payments to the lessor. A lease, then, is a form of financing to the lessee provided directly from the lessor in order to enable the lessee to purchase the use of the leased asset.
There are several advantages to leasing an asset compared to purchasing it. Leases can provide less costly financing, usually require little, if any, down payment, and are often at fixed interest rates. Because the lease contract is negotiated between the lessor and lessee, the lease may contain less restrictive provisions than other forms of borrowing. A lease can also reduce the risk of obsolescence to the lessee because the lessee does not own the asset.
Importantly, leases also have potential financial and tax reporting advantages. While providing a form of financing, certain types of leases are not shown as debt on the balance sheet. The items leased under these types of leases also do not appear as assets on the balance sheet. Therefore, no interest expense or depreciation expense is included in the income statement. In addition, in the United States, because financial reporting rules differ from tax regulations, in some cases a company may own an asset for tax purposes (and thus obtain deductions for depreciation expense for tax purposes) while not reflecting the ownership in its financial statements. A lease that is structured to provide a company with the tax benefits of ownership while not requiring the asset to be reflected on the company's financial statements is known as a synthetic lease. Next, we will discuss the two main types of leases — finance and operating— and the lessee’s and lessor’s accounting for them.
The concept of an operating lease is that the lessee can use the property for a portion of its useful life. The cost of the lease is reported as an expense by the lessee and the lessor keeps the asset on its balance sheet. This is a form of off-balance-sheet financing for the lessee.
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