CHAPTER FIVE

Leases

5.1. Nature and Definitions

A Lease can be defined as a contract where a party being the owner (lessor) of an asset (leased

asset) provides the asset for use by the lessee at a consideration (rental), either fixed or

dependent on any variables, for a certain period (lease period), either fixed or flexible, with an

understanding that at the end of such period, the asset, subject to the embedded options of the

lease, will either be returned to the lessor or disposed off as per the lessor’s instructions.

Leasing is nothing more than a method of paying for the use of an asset over a specified period

of time. Though it seems very similar to the concept of renting, they are very different.

A lease is an implied or written agreement specifying the conditions under which a lessor

accepts to let out a property to be used by a lessee. The agreement promises the lessee use of

the property for an agreed length of time while the owner is assured consistent payment over the

agreed period.

A lease is a rental agreement where a series of fixed payment is made for the use of an asset

over a period of time. Since it provides an alternative to outright purchase of an asset for use,

leasing has become an important source of intermediate and long-term financing.

A “lease” is defined as a contract between a lessor and a lessee for the hire of a specific asset

for a specific period on payment of specified rentals. The maximum period of lease according

to law is for 99 years. Previously land or real resate, mines and quarries were taken on lease.
Leasing environment

The environmental lease is a way to include consideration for the public interest

(environmental protection) into contract law. It is therefore limited to specific owners or

areas.

The environmental lease is a way to include consideration for the public interest

(environmental protection) into contract law. It is therefore limited to specific owners or

areas.

Types of leasing

There are different kinds of lease arrangements. It makes sense to consider them all to see which

is best suited to your business, your particular circumstances and the asset that you are acquiring.

The three main types of leasing are finance leasing, operating leasing and contract hire.

1. Finance leasing

 A long-term lease over the expected life of the equipment, usually three years or more,

after which you pay a nominal rent or can sell or scrap the equipment - the leasing

company will not want it any more.

 The leasing company recovers the full cost of the equipment, plus charges, over the

period of the lease.

 Although you don't own the equipment, you are responsible for maintaining and insuring

it.
  You must show the leased asset on your balance sheet as a capital item, or an item that

has been bought by the company.

 Leases of over seven years, and in some cases over five years, are known as 'long funding

leases' under which you can claim capital allowances as if you had bought the asset

outright.

2. Operating leasing

If you are considering operating leasing, remember the following points:

 it is useful if you don't need the equipment for its entire working life

 the leasing company will take the asset back at the end of the lease

 the leasing company is responsible for maintenance and insurance

 you don't have to show the asset on your balance sheet

3. Contract hire

Contract hire is often used for company cars and:

 the leasing company takes some responsibility for management and maintenance, such as

repairs and servicing

 you don't have to show the asset on your balance sheet

Elements in a Lease Structure

 Parties to a Lease
There are two parties to a lease: the owner called the lessor and the user called the lessee. The

lessor is the person who owns the asset and gives it on lease. The lessee takes the asset on lease

and uses it for the period of the lease. Ownership is no pre-condition for leasing. Technically, in

order to be a lessor, one does not have to own the asset; one has to have the right to use the asset.

Thus, a lessee can be a lessor for a sub-lessee, unless the parent lessor has restricted the right to

sub-lease.

 Leased Asset

The subject of the lease is the asset, article or property to be leased. The asset may be anything –

an automobile, land, factory, or consumer durable. Only tangible assets can be leased, you

cannot lease intangible assets, since one of the prime elements of a lease is handing over

possession, along with the right to use. Hence, intangible assets are assigned, whereas tangible

assets may be leased.

The concept of leasing will have the following limitations:

 What cannot be owned cannot be leased. Thus human resources cannot be ‘leased’.

 While lease of movable properties can be affected by mere delivery, immovable property

is incapable of deliveries in the physical sense. Most countries have specific laws relating

to transactions in immovable properties: if the law of the land requires a procedure for a

lease of immovable or real estate, such procedure should be complied.

 A lease is structurally a rental for the lease period: with the understanding that the asset

will be returned to the lesser after the period. Thus, the asset must be capable of re

delivery. It must be durable (at least during the lease period), identifiable and severable.
 The existence of the leased asset is an essential element of a lease transaction – the asset

must exist at the beginning of the lease and at the end on the lease term. Non-existence of

the asset, for whatever reason, will be fatal to the lease.

 Lease Period

The term of lease, or lease period, is the period for which the agreement of the lease shall be in

operation. As an essential element in a lease is redelivery of the asset by the lessee at the end of

the lease period, it is necessary to have a period of lease. During this certain period, the lessee

may be given a right of cancellation, and beyond this period, the lessee may be given a right of

renewal, but essentially, a lease should not amount to a sale, i.e. the asset should not be given

permanently to the lessee.

Types of Lease

Leases can be broadly classified into two:

 Financial Lease

 Operational Lease

Financial Lease

In a Financial Lease, though the device used is leasing, the purpose and effect is virtually

financing – leasing for the purpose of financing. However the generic differences between a

lease and a lease mentioned earlier still remain. The lessor will provide the money needed by the

lessee to buy an asset; in return the payments by the lessee will be in the form of lease rentals.

The lease amount is the amount that has been financed. A Financial Lease is a ‘lease look-alike’.
This lease should be treated like a lease with the lease amount as the principal and a interest

charged.

Operational Lease

It is a non-financial lease. Any other lease other than a financial lease is an operating lease. In a

financial lease, the lessor does not operate the asset he leases; he merely finances it. The word

‘operating lease’ is not applied to indicate that the lessor ‘operating’ the asset, but only as a

contra-distinction to Financial Leases. Therefore, any lease where the lessor takes a risk other

than a plain financial risk is an operating lease. This lease should be treated like a lease with no

principal and the entire lease amount as a special interest that is paid in installments.

 Lease Rental

The lease rental represents the consideration for the lease transaction. This is the amount that the

lessee pays the lessor.

If it is a Financial Lease Transaction, the rentals will simply be the recovery of the lessor’s

principal, and a certain rate of return on outstanding principal, i.e. the rentals can be seen as

bundled principal repayment and interest.

If it is an Operating Lease Transaction, the rental might include several elements depending upon

the costs and risks borne by the lessor, such as:

 Interest on the lessor’s investment

 If the lessor bears any repairs, insurance, maintenance or operation costs, the charges for

such cost.
  Depreciation of the asset

 Servicing charges or packing charges for providing a package of the above service.

 Down Payment

Down Payment is the upfront payment made by the lessee at the beginning of the lease. This is a

surrogate for the margin or borrower contribution in case of lease transaction. In the case of

financial lease, the down payment will be entirely towards the principal and in the case of

operational lease; the entire payment will be an income.

 Residual Amount

Simply put, ‘Residual Value’ means the value of the leased equipment at the end of the lease

term. If the lease contains a buy out option to buy the asset at the residual amount at the end of

the lease, this is the price at which the lessee can buy the asset from the lessor at the end of the

lease.

It is common practice to have residual amount for Financial Leases, but it is also possible for

Operational Leases to have residual amount.

Classification of lease

A lease is classified as a finance lease by a lessee and as a sales-type lease by a lessor if

ownership of the underlying asset transfers to the lessee by the end of the lease term. This

criterion is also met if the lessee is required to pay a nominal fee for the legal transfer of

ownership.
The two most common types of leases are operating leases and financing leases (also called

capital leases). In order to differentiate between the two, one must consider how fully the risks

and rewards associated with ownership of the asset have been transferred to the lessee from the

lessor.

Different types of leases

There are various types of leases like financial lease, operating, leveraged and non-leveraged,

conveyance type, Import, International lease etc.

1. Financial Lease

Financial leasing is a contract involving payment over a longer period. It is a long-term lease and

the lessee will be paying much more than the cost of the property or equipment to the lessor in

the form of lease charges. It is irrevocable. In this type of leasing the lessee has to bear all costs

and the lessor does not render any service.

2. Operating Lease

In an operating lease, the lessee uses the asset for a specific period. The lessor bears the risk of

obsolescence and incidental risks. There is an option to either party to terminate the lease after

giving notice. In this type of leasing

 lessor bears all expenses

 lessor will not be able to realize the full cost of the asset

 specialized services are provided by the lessor.

3. Leveraged and non-leveraged leases

In leveraged and non-leveraged leases, the value of the asset leased may be of a huge amount

which may not be possible for the lessor to finance. So, the lessor involves one more financier

who will have charge over the leased asset.

4. Conveyance type lease

In Conveyance type lease, the lease will be for a long-period with a clear intention of conveying

the ownership of title on the lessee.

5. Sale and leaseback

In a sale and leaseback, a company owning the asset sells it to the lessor. The lessor pays

immediately for the asset but leases the asset to the seller. Thus, the seller of the asset becomes

the lessee. The asset remains with the seller who is a lessee but the ownership is with the lessor

who is the buyer. This arrangement is done so that the selling company obtains finance for

running the business along with with the asset.

6. Full and non pay-out lease

A full pay-out lease is one in which the lessor recovers the full value of the leased asset by way

of leasing. In case of a non pay-out lease, the lessor leases out the same asset over and over

again.

7. Specialized service lease

only leases out but also gives specialized personal service to the lessee. Examples are electronic

goods, automobiles, air-conditioners, etc.

8. Net and non-net lease

In non-net lease, the lessor is in charge of maintenance insurance and other incidental expenses.

In a net lease, the lessor is not concerned with the above maintenance expenditure. The lessor

confines only to financial service.

9. Sales aid lease

In case, the lessor enters into any tie up arrangement with manufacturer for the marketing, it is

called sales aid lease.

10. Cross border lease

Lease across national frontiers are called cross border lease, Shipping, air service, etc., will come

under this category.

11. Tax oriented lease

Where the lease is not a loan on security but qualifies as a lease, it will be considered a tax

oriented lease.

12. Import Lease

country but the lessor and the lessee may belong to the same country. The equipment is more or

less imported.

13. International lease

Here, the parties to the lease transactions may belong to different countries which is almost

similar to cross border lease.

Accounting for the lessee

The lessee reports the lease as both an asset and a liability on the balance sheet due to their

stake as a potential owner of the asset and their required payment. They also report

individual lease payments as expenses on the income and cash flow statements.

The methods of accounting for a lease by the lessee are (a) operating and capital lease

methods. The lessee records two types of lease: operating and capital lease. The lessee does not

wish to acquire the asset in the case of an operating lease.

As of the commencement date of a lease, the lessee measures the liability and the right-of-use

asset associated with the lease. These measurements are derived as follows: Lease liability. The

present value of the lease payments, discounted at the discount rate for the lease.

he methods of accounting for a lease by the lessee are (a) operating and capital lease methods.

The lessee records two types of lease: operating and capital lease. The lessee does not wish to

acquire the asset in the case of an operating lease.

What is accounting by the lessor?

ownership of the underlying asset to the lessee by the end of the. lease term; (b) Grants the lessee

a purchase option that it has a significant economic.