LEASE FINANCING

Lease financing is one of the important sources of medium-and long-term financing where
the owner of an asset gives another person, the right to use that asset against periodical
payments.

The owner of the asset is known as ‘lessor’ and the user is called ‘lessee’.

The periodical payment made by the lessee to the lessor is known as lease rental.

Under lease financing, lessee is given the right to use the asset but the ownership lies with the
lessor and at the end of the lease contract, the asset is returned to the lessor or an option is given
to the lessee either to purchase the asset or to renew the lease agreement.

DIFFERENT TYPES OF LEASES

Depending upon the transfer of risk and rewards to the lessee, the period of lease and the
number of parties to the transaction, lease financing can be classified into two categories.

1. Finance lease and

2. Operating lease

1. Financial Lease: It is the lease where the lessor transfers substantially all the risks and
rewards of ownership of assets to the lessee for lease rentals. In other words, it puts the lessee in
the same condition as he/she would have been if he/she had purchased the asset. Financial lease
has two phases:

 The first one is called primary period. This is non-cancellable period and in this period,
the lessor recovers his total investment through lease rental. The primary period may last
for indefinite period of time.
 The lease rental for the secondary period is much smaller than that of primary period.

Features of Financial Lease

 A finance lease is a device that gives the lessee a right to use an asset.
 The lease rental charged by the lessor during the primary period of lease is sufficient to
recover his/her investment.

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 The lease rental for the secondary period is much smaller. This is often known as peppercorn
rental.
 Lessee is responsible for the maintenance of asset.
 No asset-based risk and rewards is taken by lessor.
 Such type of lease is non-cancellable; the investment of the lessor is assured.

2. Operating Lease: Lease other than finance lease is called operating lease. Here risks
and rewards incidental to the ownership of asset are not transferred by the lessor to the lessee.
The term of such lease is much less than the economic life of the asset and thus the total
investment of the lessor are not recovered through lease rental during the primary period
of lease.

In case of operating lease, the lessor usually provides advice to the lessee for repair,
maintenance and technical knowhow of the leased asset and that is why this type of lease is also
known as service lease.

Features of Operating Lease:

Operating lease has following features:

1. The lease term is much lower than the economic life of the asset.

2. The lessee has the right to terminate the lease by giving a short notice and no penalty is
charged for that.

3. The lessor provides the technical knowhow of the leased asset to the lessee.

4. Risks and rewards incidental to the ownership of asset are borne by the lessor.

5. Lessor has to depend on leasing of an asset to different lessee for recovery of his/her
investment.

Advantages and Disadvantages of Lease Financing: At present leasing activity shows an

increasing trend. Leasing appears to be a cost-effective alternative for using an asset. However, it
has certain advantages as well as disadvantages.

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Advantages:

Lease financing has following advantages:

A. To Lessor:

The advantages of lease financing from the point of view of lessor are summarized below: (1)
Assured Regular Income: Lessor gets lease rental by leasing an asset during the period of lease
which is an assured and regular income.

(2) Preservation of Ownership: In case of finance lease, the lessor transfers all the risk and
rewards incidental to ownership to the lessee without the transfer of ownership of asset hence the
ownership lies with the lessor.

(3) Benefit of Tax: As ownership lies with the lessor, tax benefit is enjoyed by the lessor by
way of depreciation in respect of leased asset.

(4) High Profitability: The business of leasing is highly profitable since the rate of
return based on lease rental is much higher than the interest payable on financing the
asset.

(5) High Potentiality of Growth: The demand for leasing is steadily increasing because it is
one of the cost efficient forms of financing. Economic growth can be maintained even during the
period of depression. Thus, the growth potentiality of leasing is much higher as compared to
other forms of business.

(6) Recovery of Investment: In case of finance lease, the lessor can recover the total
investment through lease rentals.

B. To Lessee:

The advantages of lease financing from the point of view of lessee are discussed below:

(1) Use of Capital Goods: A business will not have to spend a lot of money for acquiring an
asset but it can use an asset by paying small monthly or yearly rentals.

(2) Tax Benefits: A company is able to enjoy the tax advantage on lease payments as lease
payments can be deducted as a business expense.

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(3) Cheaper: Leasing is a source of financing which is cheaper than almost all other sources of
financing.

(4) Technical Assistance: Lessee gets some sort of technical support from the lessor in respect
of leased asset.

(5) Inflation Friendly: Leasing is inflation friendly, the lessee has to pay fixed amount
of rentals each year even if the cost of the asset goes up.

(6) Ownership: After the expiry of primary period, lessor offers the lessee to purchase the
assets— by paying a very small sum of money.

Disadvantages

Lease financing suffers from the following disadvantages

A. To Lessor:

Lessor suffers from certain limitations which are discussed below:

(1) Unprofitable in Case of Inflation: Lessor gets fixed amount of lease rental every year and
they cannot increase this even if the cost of asset goes up.

(2) Double Taxation: Sales tax may be charged twice: First, at the time of purchase of the
asset, and second, at the time of leasing the asset.

(3) Greater Chance of Damage of Asset: As ownership is not transferred, the lessee uses the
asset carelessly and there is a great chance that asset cannot be useable after the expiry of
primary period of lease.

B. To Lessee:

The disadvantages of lease financing from lessee’s point of view are given below:

(1) Compulsion: Finance lease is non-cancellable and even if a company does not want to use
the asset, lessee is required to pay the lease rentals.

(2) Ownership: The lessee will not become the owner of the asset at the end of lease agreement
unless he decides to purchase it.

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(3) Costly: Lease financing is more costly than other sources of financing because lessee has to
pay lease rental as well as expenses incidental to the ownership of the asset.

(4) Understatement of Asset: As lessee is not the owner of the asset, such an asset cannot be
shown in the balance sheet which leads to understatement of lessee’s asset.

Difference Between Financial Leases and Capital Leases

Financial and capital leases are particular types of leasing transactions offered to both
individuals and corporations by lending institutions such as banks, credit unions and
financial firms to purchase machinery and equipment.

Capital and financial leases offer different payback options and interest flexibility. Because
of their rigidity and tax and insurance requirements, financial leases are a better option
for large, prosperous companies, while capital leases offer flexibility that factor in both the
life of the equipment and the payback term.

Financial Lease

A financial lease is a monetary loan utilized by a corporation to purchase equipment

for its business. These full-payout loans are non-negotiable once enacted, and the lessee, not the
lending institution, is responsible for the maintenance of purchased equipment, as well as all
relevant taxes and insurance necessary for its use. In financial leases, banks merely finance
equipment for business while lessees are responsible for its upkeep.

Capital Lease

Capital leases are similar to financial leases; however, any property purchased through a
capital loan must be recorded as a taxable asset on the lessee’s financial records. Whereas
financial leases are non-negotiable once entered into, capital leases offer lessees more
flexibility. Capital leases take into account property life, or the length of time equipment is
usable. A capital lease also takes in account the ownership transfer at the end of the lease term, or
rather, the transfer of the property when the payment plan has been completed. Capital leases
also often consider the value of the property when determining the lease’s payments, so
lessees don’t have to pay more than the property is worth.