A firm may choose to purchase outright a long-lived asset, such as an airplane or an office building, giving the firm full benefit and risk from asset ownership; however it may also enter into a lease agreement with another firm, to lease an asset and assume partial benefit and risk associated with the asset.
Lessee – “borrower” of the leased asset.
Lessor – “lender” of the leased asset.
Operating Lease – typically a short-term lease where the lessor retains most of the benefits and risks associated with owning the asset.
Capital Lease – typically a long-term lease where the lessee assumes most of the benefits and risks associated with owning the asset.
In capitalizing a lease, an equal balance sheet asset and liability are created and both are reduced over the term of the lease; these reductions are expensed to the income statement.
Lessees and Operating Leases – a company may be incented to treat leases as operating leases because the financial commitment associated with the operating lease contract is not recorded on the balance sheet as a liability. Operating leases can be seen as a form of off-balance sheet financing for a company. If a lease is capitalized by a lessee, the resulting liability will have debt-like impacts on a company’s financial ratios.
Lessors and Capital Leases – companies who act as lessors may be incented to treat leases as sales-type capital leases in order to show higher net income.
