Leases

A firm often borrows money to finance the acquisition of an asset needed for its operations. An alternative approach that might accomplish the same goal is to lease the asset. In a lease, the firm commits to making fixed payments to the owner of the asset for the rights to use the asset. These fixed payments are either fully or partially tax deductible, depending upon how the lease is categorized for accounting purposes. Failure to make lease payments initially results in the loss of the leased asset, but can result in bankruptcy, though the claims of the lessors (owners of the leased assets) may sometimes be subordinated to the claims of other lenders to the firm.

A lease agreement is usually categorized as either an operating lease or a capital lease. For operating leases, the term of the lease agreement is shorter than the life of the asset, and the present value of lease payments is generally much lower than the actual price of the asset. At the end of the life of the lease, the asset reverts back to the lessor, who will either offer to sell it to the lessee or lease it to somebody else. The lessee usually has the right to cancel the lease and return the asset to the lessor. Thus, the ownership of the asset in an operating lease clearly resides with the lessor, with the lessee bearing little or no risk if the asset becomes obsolete. Operating leases cover be the store spaces leased out by specialty retailing firms like the Gap and Ann Taylor, for instance.A capital lease generally lasts for the life of the asset, with the present value of lease payments covering the price of the asset. A capital lease generally cannot be canceled, and the lease can be renewed at the end of its life at a reduced rate or the asset acquired by the lessee at a favorable price. In many cases, the lessor is not obligated to pay insurance and taxes on the asset, leaving these obligations up to the lessee; the lessee consequently reduces the lease payments, leading to what are called net leases. A capital lease places substantial risk on the shoulders of the lessee, if the asset loses value or becomes obsolete. While the differences between operating and financial leases are obvious, some lease arrangements do not fit neatly into one or another of these extremes; rather, they share some features of both types of leases. These leases are called combination leases.

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