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LEASING VERSUS BUYING

As far as the lessee is concerned, it is the use of the asset that is important, not necessarily who has title to it. One way to obtain the use of an asset is to lease it. Another way is to obtain outside financing and buy it. Thus, the decision to lease or buy amounts to a comparison of alternative financing arrangements for the use of an asset. Figure B.1 compares leasing and buying. The lessee, Sass Company, might be a hospital, a law firm, or any other firm that uses computers. The lessor is an independent leasing company that purchased the computer from a manufacturer such as Hewlett-

Packard (HP). Leases of this type, in which the leasing company purchases the asset from the manufacturer, are called direct leases. Of course, HP might choose to lease itsown computers, and many companies, including HP and some of the other companies mentioned previously, have set up wholly owned subsidiaries called captive finance companies to lease out their products.1

As shown in Figure B.1, whether it leases or buys, Sass Company ends up using the asset. The key difference is that in one case (buy), Sass arranges the financing, purchases the asset, and holds title to the asset. In the other case (lease), the leasing company arranges the financing, purchases the asset, and holds title to the asset.

OPERATING LEASES

Years ago, a lease in which the lessee received an equipment operator along with the equipment was called an operating lease. Today, an operating lease (or service lease) is difficult to define precisely, but this form of leasing has several important characteristics. First of all, with an operating lease, the payments received by the lessor are usually not enough to allow the lessor to fully recover the cost of the asset. A primary reason is that operating leases are often relatively short-term. Therefore, the life of the lease may be much shorter than the economic life of the asset.

For example, if you lease a car for two years, the car will have a substantial residual value at the end of the lease, and the lease payments you make will pay off only a fraction of the original cost of the car. The lessor in an operating lease expects to either lease the asset again or sell it when the lease terminates.

A second characteristic of an operating lease is that it frequently requires that the lessor maintain the asset. The lessor may also be responsible for any taxes or insurance. Of course, these costs will be passed on, at least in part, to the lessee in the form of higher lease payments.

The third, and perhaps most interesting, feature of an operating lease is the cancellation option. This option can give the lessee the right to cancel the lease before the expiration date. If the option to cancel is exercised, the lessee returns the equipment to the lessor and ceases to make payments. The value of a cancelation clause depends on whether technological and/or economic conditions are likely to make the value of the asset to the lessee less than the present value of the future lease payments under the lease.

To leasing practitioners, these three characteristics define an operating lease. However, as we will see shortly, accountants use the term in a somewhat different way.

OPERATING LEASE Usually a shorter-term lease under which the lessor is responsible for insurance, taxes, and upkeep. May be cancelable by the lessee on short notice.