Types of Lease: Financial Lease, Operating Lease, Leverage Lease

29/12/2020 1 By indiafreenotes

Definition:

(i) Lessor:

The party who is the owner of the equipment permitting the use of the same by the other party on payment of a periodical amount.

(ii) Lessee:

The party who acquires the right to use equipment for which he pays periodically.

Lease Rentals:

This refers to the consideration received by the lessor in respect of a transaction and includes:

(i) Interest on the lessor’s investment;

(ii) Charges borne by the lessor. Such as repairs, maintenance, insurance, etc;

(iii) Depreciation;

(iv) Servicing charges.

Types of Leases:

The different types of leases are discussed below:

  1. Financial Lease:

This type of lease which is for a long period provides for the use of asset during the primary lease period which devotes almost the entire life of the asset. The lessor assumes the role of a financier and hence services of repairs, maintenance etc., are not provided by him. The legal title is retained by the lessor who has no option to terminate the lease agreement.

The principal and interest of the lessor is recouped by him during the desired playback period in the form of lease rentals. The finance lease is also called capital lease is a loan in disguise. The lessor thus is typically a financial institution and does not render specialized service in connection with the asset.

Main features of a Financial Lease

  • The lessee (borrower or customer) selects an asset (equipment, software, vehicle
  • The lessor (finance company) purchases that asset
  • The lessee uses that asset during the lease
  • The lessee pays a series of installments or rentals for using that asset
  • The lessor recovers a large part or almost complete cost of the asset in addition to earning interest from the rentals paid by the lessee
  • The lessee has the option of acquiring ownership of the asset (bargain option purchase price or paying the last rental)

Impact of Financial Lease on Accounting

  • Being capitalized, a financial lease leads to an increase in assets as well as liabilities present in the balance sheet. Consequently, working capital falls, but an additional leverage is created by an increase in the debt-equity ratio.
  • Lease obligations are not recognized under operating lease conditions, thus, resulting in understated leverage ratios and overstated ratios of return.
  • In a cash flow statement, part of lease payments are reported under operating cash flow and part under financing cash flow because of financial lease expenses being allocated between principal expense and interest expense akin to a loan or bond.
  1. Operating Lease:

It is where the asset is not wholly amortized during the non-cancellable period, if any, of the lease and where the lessor does not rely for is profit on the rentals in the non- cancellable period. In this type of lease, the lessor who bears the cost of insurance, machinery, maintenance, repair costs, etc. is unable to realize the full cost of equipment and other incidental charges during the initial period of lease.

The lessee uses the asset for a specified time. The lessor bears the risk of obsolescence and incidental risks. Either party to the lease may termite the lease after giving due notice of the same since the asset may be leased out to other willing leases.

Operating Lease Accounting by Lessee

  • A lease cost in each period, where the total cost of the lease is allocated over the lease term on a straight-line basis. This can be altered if there is another systematic and rational basis of allocation that more closely follows the benefit usage pattern to be derived from the underlying asset.
  • Any variable lease payments that are not included in the lease liability
  • Any impairment of the right-of-use asset

After the commencement date, the lessee measures the right-of-use asset at the amount of the lease liability, adjusted for the following items:

  • Any impairment of the asset
  • Prepaid or accrued lease payments
  • Any remaining balance of lease incentives received
  • Any unamortized initial direct costs

Operating Lease Accounting by Lessor

At the commencement date of an operating lease, the lessor shall defer all initial direct costs. In addition, the lessor must account for the following items subsequent to the commencement date of the lease:

  • Lease payments. Lease payments are recognized in profit or loss over the term of the lease on a straight-line basis, unless another systematic and rational basis more clearly represents the benefit that the lessee is deriving from the underlying asset. Profits cannot be recognized at the beginning of an operating lease, since control of the underlying asset has not been transferred to the lessee.
  • Variable lease payments. If there are any variable lease payments, record them in profit or loss in the same reporting period as the events that triggered the payments.
  • Initial direct costs. Recognize initial direct costs as an expense over the term of the lease, using the same recognition basis that was used for the recognition of lease income.
  1. Sale and Lease Back Leasing:

To raise funds a company may-sell an asset which belongs to the lessor with whom the ownership vests from there on. Subsequently, the lessor leases the same asset to the company (the lessee) who uses it. The asset thus remains with the lessee with the change in title to the lessor thus enabling the company to procure the much-needed finance.

  1. Sales Aid Lease:

Under this arrangement the lessor agrees with the manufacturer to market his product through his leasing operations, in return for which the manufacturer agrees to pay him a commission.

  1. Specialized Service Lease:

In this type of agreement, the lessor provides specialized personal services in addition to providing its use.

  1. Small Ticket and Big-Ticket Leases:

The lease of assets in smaller value is generally called as small ticket leases and larger value assets are called big ticket leases.

  1. Cross Border Lease:

Lease across the national frontiers is called cross broker leasing. The recent development in economic liberalisation, the cross-border leasing is gaining greater importance in areas like aviation, shipping and other costly assets which base likely to become absolute due to technological changes.

  1. Leverage Lease

A leveraged lease or leased lender is a lease in which the lessor puts up some of the money required to purchase the asset and borrows the rest from a lender. The lender is given a senior secured interest on the asset and an assignment of the lease and lease payments. The lessee typically makes payments directly to the lender as the lease payments are assigned to the lender.

The term may also refer to a lease agreement wherein the lessor, by borrowing funds from a lending institution, finances the purchase of the asset being leased.

The lessor pays the lending institution back by way of the lease payments received from the lessee. Under the loan agreement, the lender has rights to the asset and the lease payments if the lessor defaults.

A leveraged lease is a tax-advantaged lease arrangement in which a lessor borrows funds to acquire an asset that is then leased to a lessee. In this situation, the lender holds title to the leased asset, while all lessee payments are collected by the lessor and passed to the lender. The lender can repossess the asset in the event of a lessee payment default. In this arrangement, the lessor can recognize depreciation expense on the asset for tax purposes, while the lessee can deduct its lease payments from taxable income.

The name of this lease refers to the financing position of the lessor, which has used debt (leverage) to pay for most of the cost of the asset that is being leased.

Merits of Leasing:

(i) The most important merit of leasing is flexibility. The leasing company modifies the arrangements to suit the leases requirements.

(ii) In the leasing deal less documentation is involved, when compared to term loans from financial institutions.

(iii) It is an alternative source to obtain loan and other facilities from financial institutions. That is the reason why banking companies and financial institutions are now entering into leasing business as this method of finance is more acceptable to manufacturing units.

(iv) The full amount (100%) financing for the cost of equipment may be made available by a leasing company. Whereas banks and other financial institutions may not provide for the same.

(v) The ‘Sale and Lease Bank’ arrangement enables the lessees to borrow in case of any financial crisis.

(vi) The lessee can avail tax benefits depending upon his tax status.

Demerits of Leasing:

(i) In leasing the cost of interest is very high.

(ii) The asset reverts back to the owner on the termination of the lease period and the lesser loses his claim on the residual value.

(iii) Leasing is not useful in setting up new projects as the rentals become payable soon after the acquisition of assets.

(iv) The lessor generally leases out assets which are purchased by him with the help of bank credit. In the event of a default made by the lessor in making the payment to the bank, the asset would be seized by the bank much to the disadvantage of the lessee.