Leasing is a beneficial way for businesses to obtain different assets without having to pay an upfront purchase price, or without acquiring it at all. Lease agreements usually involve a deal between two parties, the lessor and the lessee.
A lessor is a party that owns the asset and gives it to the lessee, the party that receives it. The lessee then pays the lessor in exchange for the leased asset.
Leasing isn’t only for small businesses. Even large size businesses use leases as a way to distribute the cost of an asset over some time.
Furthermore, leasing can be very beneficial for planning, budgeting, cash flow management, working capital management, and many aspects of a business. A lease can be mutually beneficial to both the lessor and the lessee.
When it comes to leasing, there are two major types, known as capital leases and operating leases. Businesses need to understand the differences between these two types to allow them to make better decisions related to their leases.
Capital lease
A capital lease is a leasing agreement in which the risks and rewards of the leased asset get transferred to the lessee. These are generally long-term leases, as compared to operating leases.
In a capital lease agreement, the lessor usually transfers the leased asset to the lessee at the end of the lease agreement.
Even if there is no transfer of the asset is involved, the lessee takes advantage of most of its useful life. There are also several other factors that define a capital lease and differentiate it from an operating lease.
Operating lease
An operating lease is different from a capital lease and is a short-term lease. In an operating lease, the risks and rewards of an asset stay with the lessor.
Since operating leases are short-term, the lessor gets to use a majority of the useful life of the asset instead of the lessee.
Similarly, there is no transfer of the asset to the lessee at the end of an operating lease, thus, making it different from a capital lease.
To determine whether a lease qualifies as an operating lease, the parties must evaluate whether it meets the requirements to qualify as a capital lease. If it does not qualify as a capital lease, it is an operating lease.
Combination lease
Some leases may offer features of both a capital lease and an operating lease. Combination leases are more customizable as it allows the lessor and lessee to decide the terms of the lease that suit them.
An example of a combination lease is a short-term operating lease that also has a transfer clause for the lessee to receive the asset after the period of the lease. Operating leases do not come with a transfer clause, but capital leases do. Therefore, this lease is a combination of both.
Combination leases may also have some non-lease components. These are components that do not exist in other leases. Usually, lessors include these components in a lease to demand specific conditions for lessees to meet.
Therefore, combination leases come into being when there are lease and non-lease components included in a lease agreement, which may also have the qualities of capital and operating lease.
Combination leases are often necessary for large projects where one party signs many different contracts with the other. Some of these contracts may also be interlinked and, therefore, the parties may need to complete them at the same time or at least perform them parallelly.
Since there are many different contracts involved, there is also a need for the involved parties to meet specific conditions.
The accounting treatment of combination leases under IFRS requires a business to combine contracts that it enters simultaneously with the same counterparty.
Furthermore, IFRS requires the business to separate the lease and non-lease components of a lease agreement for contracts that include non-lease components as well.
These non-lease components may consist of services that the lessor agrees to provide to the lessee in the lease agreement. For example, a lessee leases an asset from a lessor, that also agrees to provide maintenance services to the lessee.
Conclusion
A lease is a contract in which a lessor agrees to provide an asset to a lessee in exchange for regular lease payments. There are two main types of leases that businesses can enter into, capital lease and operating lease.
Combination leases are a less common type of leases which consists of characteristics of both capital and operating leases.
Combination leases may also include some non-lease components. When accounting for combination leases, a business must treat all contracts as a single contract if made with the same party at the same time.
Similarly, IFRS requires businesses to separate the lease and non-lease components of a contract as well.
