The Basics of Accounting for Leases - dummies

The Basics of Accounting for Leases

By Maire Loughran

Businesses don’t always buy their fixed assets, which include property, plant, and equipment. Sometimes they lease those assets. You’ve probably been a party to a lease yourself at some time: Even if you own your own home now, you probably rented either a house or an apartment in the past.

Signing a lease on an apartment is rarely more complicated than coughing up the cash and signing on the bottom line, but business leases are trickier. So you can’t automatically equate a business lease to a personal rental.

When renting an apartment, you have no claim to it after your lease expires. Depending on how a business lease is set up, however, a company may be the eventual owner of the leased equipment. The terms of the lease also have an effect on how financial accountants book the lease payments.

Leasing instead of flat-out purchasing business assets has grown in popularity over the past couple decades. The reason is that although businesses need tangible assets, they don’t want to tie up money in acquiring these assets. Enter the lease, which is a way to get property, plant, and equipment while eliminating the up-front costs inherent in purchasing.

Normally, a lease involves two parties. The lessor owns the property and grants the lessee the right to use it. In today’s marketplace, lessors fall into three classes: banks, captive leasing companies, and independents.

  • Banks: Many banks conducting what you consider “normal” bank activities (such as accepting money on deposit and lending the funds back out) also have leasing subsidiaries. These subsidiaries acquire all manner of fixed assets and then lease them to businesses.

  • Captive leasing companies: These leasing companies are subsidiaries of parent companies and handle the leasing of the parent company’s tangible assets. For example, Ford Motor Credit is the captive leasing company for Ford Motor Company. Ever leased a car you hated? You probably ended up feeling like a captive!

    When a business owns more than 50 percent of another business, the investor business is called a parent and the investee is the subsidiary, or sub, for short.

  • Independents: Any leasing company that’s not a bank or a captive falls into this category. It’s hard for independents to make a buck in this economy. They lack the financing power and availability of ready cash of a bank. Independents also don’t have the built-in customer base available to leasing companies with parents such as Ford and other large manufacturers.

An interesting fact about leases is that the lessor doesn’t necessarily own the fixed asset just prior to entering into a lease agreement. Sometimes purchasing the fixed asset is contingent upon finalizing the lease agreement. In other words, as part of the agreement, the lessor commits to purchasing the leased asset. This situation may happen if the piece of equipment is expensive or isn’t an asset in high demand.