Direct Financing vs. Sales-Type Leases

Accounting rules allow for three kinds of leases. An operating lease is one in which the lessor (leasing company) grants the lessee the right to use the property. Capital leases fall into two categories: direct-financing and sales-type. Capital leases allow the lessee some benefits of ownership. On the flip side, leasing is more expensive than buying the asset outright because the lessee pays for the asset and lease charges.

According to the Financial Accounting Standards Board, a lease receives treatment as a capital lease if it meets one of four criteria. A lease is a capital lease if: the lease term exceeds 75 percent of the life of the asset; there is a transfer of ownership at the end of the lease term; there is an option to pay for the asset at a "bargain price."; or if the present value of lease payments (using an appropriate discount rate) exceeds 90 percent of the fair value of the asset.

A direct-financing lease combines a sale and financing transaction. The lessor records a sale on its books, removing the asset from its books and replacing it with a receivable from the lease. During the lease term, the lessor receives interest income, calculated by taking the internal rate of return of the asset. The cash inflow equals the lease payments and the cash outflow is equal to the book value of the asset.

A sales-type lease receives the same accounting treatment of a direct-financing lease except the profit of the sale is recognized at inception of the lease as well as the interest income received over the lease term. The lessor records a gross profit from the lease equivalent to the present value of the lease payments less the cost of the asset.

Companies often choose to lease rather than buy an asset for a variety of reasons. One reason is that a lease allows the company to adjust to changes in technology and capacity needs without having to make a large capital commitment. A capital lease allows the lessee to enjoy some of the benefits of ownership, such as claiming depreciation each year and deducting the interest component of the lease payments. One major disadvantage of leasing is lack of ownership and cost. Over the life of the asset, a company pays for the cost of the equipment plus the leasing company's charges.