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It may help to understand Leasing in the context of comparing it to a Loan.
A loan is a legal contract evidenced by a promissory note. By its terms, one party (the "payee") lends money to another party ("the payor") to acquire property or equipment. A home mortgage, for instance, is a loan.
The promissory note requires the payor to make specified periodic payments of principal and interest to the payee until the property or equipment is fully paid. The property or equipment serves as collateral for the loan.
Like a loan, a lease is a legal contract. By its terms, one party (the "lessor") gives another party (the "lessee") the exclusive right to use and possess its property or equipment for a specified period. The contract requires the lessee to make periodic payments ("rentals") to the lessor for the use of the leased equipment.
At the end of the lease term, the lessee has several options:
In any organization, there are three primary constituents who evaluate leases; each with its own objectives and own set of standards and rules. They determine lease status not on what the lease document says ("Form of the Transaction"), but on the intent of the lessee and lessor when they entered into the contract ("Substance of the Transaction"). The three constituents are:
Basically, these professionals want to know if the acquirer is really buying the equipment or is simply renting it. The answer may differ depending on the point of view of the accountant versus the tax counselor versus the attorney. For greater insight, seek advice from these professionals in your organization.
Leases can be structured in a couple of ways. The three most common are:
Fair Market Value (FMV)
FMV refers to the value of the equipment at the end of the lease term. So, the cost of an FMV lease is discounted by the expected value (i.e. residual) of the equipment when the lease is completed (usual timeframes are 12-60 months). Unlike the $1 Buy-Out lease (described below), the lessee is not considered the owner of the equipment. The lessor depreciates the equipment and can pass the benefit on to the lessee in the form of lower monthly payments. This explains why FMV rates typically are lower than $1 Buy-Out or 10% Purchase Option rates.
When to Consider
$1 Purchase Option
The lease is structured so the lessee can purchase the equipment at the end of term for $1. It provides the benefit of a loan (ownership) with the advantage of a lease (lower payments). Typical lease terms are 12-60 months.
When to Consider
10% Purchase Option
Similar to the $1 Buy-Out structure except the purchase price at end of term is 10% of the equipment's value as determined at the start of the lease.
When to Consider
