What is leasing?
A lease is referred to as a contract in which the property owner allows another party to use the property (or asset) in exchange for something. Leasing continues to be the top choice of financing for companies, primarily because of the fact that it helps companies to take full utility of the assets, without having to pay upfront costs of purchasing the asset.
When companies are faced with the issue of expansion, they might not always have the resources to do so. This is because capital expenditures require substantial cash, and in most cases, organizations are not that self-sufficient in terms of cash.
Therefore, leasing can be best described as a process that involves one party procuring an asset from the other party at an added cost. The concept of leasing has been around for a considerable time frame, because of the advantages it offers to both, the lessor, as well as the lessee. There are numerous different types of leasing options that are available to the users.
These options vary on grounds of the position of the business, and what they want to utilize in the form of assets. However, regardless of the various different kinds of lease contracts present, it can be seen that the most common types of lease types are Operating Lease contracts and Capital Lease contracts. A subsequent definition of lease types is mentioned in the next section.
Types of Leasing
- Financial Lease: Financial Lease, also referred to as a capital lease, is a lease contract that spreads over a longer period of time. Therefore, it is considered to be a long-term lease. In a financial lease, the lessee ends up paying a higher amount for purchasing the asset, because it expands over a significant amount of time, and also includes lease charge (and interest charge). This lease charge and the interest charge tend to be the profit from the perspective of the lessor.
- Operating Lease: As far as the operating lease is concerned, it can be seen that the lessee procures the asset that is supposed to be used for a specific time period. At the end of the lease period, the ownership of the leased asset is not transferred to the owner, and therefore, the lessor is supposed to bear the expenses of maintenance of the asset. In the same manner, the risk of obsolescence is also borne by the lessor in this case.
- Leveraged and Non-Leveraged Lease: These types of lease contracts are mostly used in cases where the underlying value of the asset is considered to be quite significant, so much so that it is almost impossible for one investor to fully finance the asset. Therefore, leveraged lease contracts might involve a combination of investors who club their funds together in order to finance the asset.
- Conveyance Type Lease: A conveyance Type Lease is quite similar to a capital lease, because of the fact that it mainly involves the transfer of ownership at the end period of the contract. s
- Sale and Leaseback: Sale and Leaseback involve the company that owns the asset to sell it, and then lease it back from the purchaser of the asset. The main aim of this particular lease category is for the lessee (i.e. the previous owner of the asset) to have cash in hand as a result of selling the asset. The advantage is the fact that they can still be able to use the asset despite having sold it to the lessor.
Main types of Leasing: The Most Popular Lease Contracts
As mentioned earlier, it can be seen that the most commonly used lease types are classified as Operating Lease Contracts, and Capital Lease Contracts. Further description of these types of lease contracts are given below:
Financing Lease Contracts (Capital Lease Contracts)
Finance lease contracts are long-term contracts, which mostly span over the expedited life of the equipment. This is mostly used for assets that have a life of at least one year. The lessee benefits from this particular lease contract in the manner that they tend to use the asset, and capitalize it in the financial statements. The liability is then periodically reduced with payments which is a combination of interest payments, as well as lease charges. This tends to be the profit for the lessor. There are certain criteria that need to be met in the case of financial lease contracts. These criteria are summarized below:
- Ownership: In the case of a financial lease, the ownership contracts are shifted from the lessor to the lessee by the end of the lease period.
- Bargain Purchase Option: Under the financial lease, the lessee can purchase the asset from the lessor at the end of the lease term at a competitive price.
- Lease Term: The lease period should ideally cover at least 75% of the useful life of the asset. During the lease period, the contract is non-retractable.
- Present Value: The present value of the minimum lease payments required under the capital lease contract amounts to be around 90% of the fair value of the asset that exists at the beginning of the lease.
In order for a lease to be classified as financing lease, the aforementioned criteria should be fulfilled.
In the case of capital lease, the present value of the payments that are made to the lessor are considered to be the cost of the asset. It is capitalized in the Balance Sheet as a Fixed Asset. The corresponding credit entry is made in the Capital Lease Liability Account.
Operating Lease Contracts
As far as the operating lease is concerned, it can be seen that an operating lease is considered to be a contract that allows the lessee to use the asset, without any transfer of the ownership rights. If any of the criteria mentioned above for a financial lease is not fulfilled, the particular lease contract is referred to as an operating lease. For example, they do not include the transfer of ownership to the lessee during and after the lease period. Similarly, they cannot include a bargain purchase option.
As far as the operating lease contract is concerned, it can be seen that there is no ownership risk on the part of the lessee. Therefore, the lessee can only have the right to use the asset, whereas the risk and the benefits are contained by the lessor. Operating lease contracts are for a shorter time duration, and therefore, the lessee pays the maintenance costs.
Advantages of Leasing
Leasing tends to be a highly popular choice for companies to help them procure assets without having to invest hefty cash upfront. It provides a number of benefits that justify its relative growth over the years. The benefits of leasing are summarized below:
- The relative ease of payment schedules as compared to other financing payment options.
- Lower after-tax costs
- Better usage of capital: The cash that is saved from investing upfront into the asset can be used elsewhere by the organization.
- No risk of obsolescence: In the case of an operating lease, it can be seen that there is no risk of the asset being declared obsolete because the ownership is not retained with the lessee.
However, getting into a lease contract does involve some complications. There are several different checks and balances that need to be undertaken by the lessor in order to ensure that the overall risk of the buyer is limited in terms of the lessee being unable to honor the lease payments. In the same manner, it is also important for the lessee to plan the present value of the payments to ensure that the final leased cost of the asset does not increasingly exceed the market value of the asset.