Types of lease and their implications

  • Financial Lease:

A lease is considered as a financial lease if the lessor intends to recover his capital outlay plus the required rate of return on funds during the period of lease.

It is a form of financing the assets under the cover of lease transaction.

In this type of leases, lessee will use and have control over the asset without holding the title to it.

The lessee acquires most of the economic values associated with the outright ownership of the asset.

The lessee is expected to pay for upkeep and maintenance of the asset.

This is also known by the name ‘capital lease.

The essential point of this type of lease agreement is that it contains a condition whereby the lessor agrees to transfer the title for the asset at the end of the lease period at a nominal cost.

At the end of lease it must give an option to the lessee to purchase the asset he has used at the expiry of the lease.

Under this lease usually 90% of the fair value of the asset is recovered by the lessor as lease rentals and the lease period is 75% of the economic life of the asset.

The lease agreement is irrevocable.

Practically all the risks incidental to the asset ownership and all the benefits arising therefrom is transferred to the lessee who bears the cost of maintenance, insurance and repairs.

Only the title deeds remain with the lessor.

This lease is preferred in the following situations:

(i) When the lessee wants to own the asset but does not have enough funds to invest.

(ii) The time period to use the asset is substantially long at lower lease rentals.

  • Operating Lease:

An operating lease is similar to the financial lease in almost all aspects.

This lease agreement gives to the lessee only a limited right to use the asset.

The operating lease is generally for a short-term, where the lessor is usually the manufacturer of the asset, who want to increase his sales by allowing the customers to pay in installments for a short-term and ultimately the title to the asset will be transferred to the lessee on making full payment.

In some cases the lessor keeps the title to the goods and he continues to lease the asset to other party until the life of the asset is completed.

In the operating lease, it is the responsibility of the lessee to maintain and upkeep the asset properly when the asset is under his control.

The lessor will enjoy the depreciation claim and the lessee will show his lease rentals and asset maintenance expenses as business expenditure.

At the end of the life of the asset, it will be sold off by the lessor to get the salvage value.

This lease is preferred in the following situations:

(i) When the long-term suitability of asset is uncertain.

(ii) When the asset is subject to rapid obsolescence.

(iii) When the asset is required for immediate use to tie over a temporary problem.

Sale and Lease Back:

Under this the lessee first purchases the equipment of his choice and then sells it to the lessor firm.

The lessor in turn leases out the asset to the same lessee.

The advantage of this method is that the lessee can satisfy himself completely regarding the quality of the asset and after possession of the asset convert the sale into a lease arrangement.

This option he can exercise even in the case of an old asset used by him for some time to get the release of a lump-sum cash which he can put into alternative use.

The lessor gets the tax credit for depreciation.

This method of financing an asset is also popular when the lessee is in liquidity problems, he can sell the asset to a leasing company and takes it back on lease.

This will improve the liquidity position of the lessee and will continue to use the asset without parting with it.

  • Leveraged Lease:

In this form of lease agreement, the lessor undertakes to finance only a part of the money required to purchase the asset.

The major part of the finance is arranged with a financier to whom the title deeds for the asset as well as the lease retails are assigned.

There are usually three parties involved, the lessor, the lessee and the financier.

The lease agreement is between the lessee and lessor as in any other case. But it is supplemented by another separate agreement between the lessor and the financier who agrees to provide a major part (say 75%) of the money required.

This is a type of lease agreement which will enable the lessor to undertake an expand volume of lease business with a limited amount of capital and hence it is named leverage leasing.

  • Sales Aid Leasing:

A leasing company will enter into an agreement with the seller, usually manufacturer of the equipment, to market the latter’s product through its leasing operations.

The leasing company will also get commission for such sales, which add up to its profits.

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