Lease: Definition and Types | Financial Management

In this article we will discuss about:- 1. Definition of Lease 2. Features of Lease 3. Types of Leases 4. Structure of Lease Rentals.

Definition of Lease:

World over leasing has emerged as an innovative technique of financing industrial equipment. In India leasing has been developed as an important supplementary source of finance and is gaining increased acceptance from the industries. A number of non-banking financial companies have shot up and many leading banks started wholly-owned subsidiaries to transact leasing business.

Leading financial institutions have also entered into the business of equipment leasing and financing. The importance of leasing can hardly be over emphasized. The technique of leasing gives the facility to possess and operate the asset without owning the asset. It is a method of financing where huge capital outlays are substituted by periodical rental payments.

Under a typical leasing transaction, a lessor acquires the title to the equipment to be leased by paying 100 per cent value for the asset identified by the lessee and then leases it out to the lessee under a lease agreement for a period normally less than the depreciable life of the asset.

Lease finance can be said to be a “contract between lessor and lessee whereby the former acquires the equipment/goods/plant as required and specified by the lessee and passes on the goods to the lessee for use for a specific place and in consideration promises to pay the lessor a specified sum in a specified mode at specific interval and at a specified place”.

Under the lease financing, an asset can be acquired without incurring the initial purchase cost by just making payment of lease rentals over a specified period of the lease contract. It is more or less an off-balance sheet financing, where neither the acquisition of asset nor the loan is to be shown in the financial position statement.

The periodical lease rentals paid will be shown in the financial position statement as business expenditure. It is basically a contract whereby the owner of the asset (the lessor) grants to another party (the lessee) to exclusive right to use the asset for an agreed period of time, for an agreed amount payable on periodical basis (lease rentals) over the specified lease period.

The lease transaction may be broadly equated to an installment credit being extended to the person using the asset by the owner of the asset, but without transferring the title of ownership.

Features of Lease:

The important features of lease contract are as follows:

(a) The lease finance is a contract.

(b) The parties to contract are lessor and lessee.

(c) Equipment are bought by lessor at the request of lessee.

(d) The lease contract specifies the period of contract.

(e) The lessee uses these equipment’s.

(f) The lessee, in consideration, pays the lease rentals to the lessor.

(g) The lessor is the owner of the assets and is entitled to the benefit of depreciation and other allied benefits e.g., under sections 32A and 32B of the Income-tax Act.

(h) The lessee claims the rentals as expenses chargeable to his income.

The last two items are basically related to the accounting practice.

Types of Leases:

Lease agreements are basically of two types.

They are:

(a) Financial lease, and

(b) Operating lease. The other variations in lease agreements are

(c) Sale and lease back,

(d) Leveraged leasing, and

(e) Sales aid leasing.

i. 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. A financial lease ‘is a non-cancellable contractual commitment on the part of the lessee (the user) to make a series of payments to the lessor for the use of an asset.

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. The financial lease is generally given for a long period of time.

The lessor recovers the cost of asset along with profit during the primary lease period. The lease finance companies will come forward for financing the asset that is required by the lessee, to earn return on capital outlay by fixing the lease rent in such a way to recover their desired profit. The finance company will become the lessor in such cases.

This lease is preferred in the following situations:

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

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

ii. 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.

The main characteristics of operating lease are as follows:

(a) The lease can be cancelled by the lessee prior to its expiration at a short notice.

(b) The lessor is responsible for upkeep and maintenance of the asset.

(c) The lessee is not given any uplift to purchase the asset at the end of the lease period.

(d) The lease is for a smaller period.

(e) The sum of all the lease payments by the lessee does not necessarily fully provide for the recovery of cost of the asset.

(f) The lessor has the option to lease out the asset again to another party.

This is the popular type of lease in most of the advanced countries, under this it is easy to lease an asset on an experimental basis to know its exact profitability. The lessee is protected against the risk of technical obsolescence. For the use of costly equipment, for a limited period, it is the best method.

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.

iii. 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 lumpsum 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.

iv. 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.

v. 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.

Structure of Lease Rentals:

The lease rents are payable on periodical basis over the specified lease period. The lease rentals should be structured in such a way that it will be convenient for both lessor and lessee. In a competitive situation, the lessee will tend to obtain lease finance where the lease rentals are lowest. The lessor has to recover his principal amount invested as well as the desired return on investment.

Lease rent structure may be in the following ways:

i. Equal Annual Plan:

In this plan, the annual lease rent payable is divided into equal amounts by applying the annuity factor for the specified period of lease at a predetermined interest rate taken as discount rate.

ii. Stepped-Up Plan:

Under this plan, the annual lease rent will go on increasing every year with a specified rate of increase.

iii. Balloon Payment Plan:

In this plan, the annual lease rent payable in the initial year would be less, fixed up in such a way to meet the nominal amount comparative to the cost of investment, but the ending years of lease periods, the rest of the amount is payable in lump sum.

iv. Deferred Payment Plan:

Under this plan, the lease rent need not be paid for the initial specified period. But lease rent payable in the subsequent period, in equal annual amounts will recover the cost of financing for the deferred payment period also.