Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Lease Payments

What it is:

There are many kinds of leases and thus many ways to calculate and record lease payments. Some allow the lessee to buy the asset at the end of the lease term, some do not, for example. For example, there are two general types of leases: operating leases and capital leases. An operating lease is simply a lease on an asset that does not give the lessee rights similar to those of an owner of the asset. Generally, lease payments made under a capital lease go on the income statement and thus reduce profits.

A capital lease is the opposite—it gives the lessee rights similar to those of an owner of the asset. Generally, lease payments made under a capital lease are recorded on the balance sheet and thus do not reduce profits.

GAAP rules state that to determine whether the lease is an operating lease, the lease must not have any of these characteristics:
1. The life of the lease must not be longer than 75% of the life of the asset.
2. The lessor cannot transfer ownership of the asset to the lessee at the end of the lease term.
3. There cannot be an option to purchase the asset at a "bargain price" at the end of the lease term.
4. The present value of the lease payments cannot exceed 90% of the fair market value of the asset.
 
Because they are legal obligations, lease payments are also included in calculations of a company's fixed-charge coverage ratio, which is a measure of liquidity.
 

How it works (Example):

Leases can be for a variety of assets, though real estate often comes to mind first. For example, let's say John Doe owns a house on Main Street. He does not live in the house; he decides to lease it to Jane Smith. John continues to be the owner of the house, but Jane agrees to pay John $800 a month in return for letting her live there for a year. The $800 is Jane's lease payment.

Leases can also be for cars, manufacturing equipment, office space, photocopiers, musical instruments, solar panels, or virtually any other asset. Generally, leases are handy when one party has the capital to purchase the asset and another party does not have the capital to do so but would like access to the asset. Accordingly, it's possible to have lease payments for a variety of things.

Why it Matters:

A lease payment is a payment pursuant to a lease agreement, usually written, between the owner of an asset and a lessee.