Types and Examples of Leasing

Leasing is an old method of financing which is now gaining popularity almost in whole world. Legally, the lease contract is not a sale of the object, but rather a sale of the usufruct (the right to use the object) for a specified period of time. Under leasing there are two parties one is the owner or lessor of the asset and other is the lessee or the party that takes the asset on lease. The lessee takes the asset for use for a specified period of time and makes rental payments. The ownership of the asset rests with the lessor but it is in the possession of lessee and right of use is also transferred to lessee.

Following are different types of leasing. The two basic types of leasing are: Finance Lease and Operating Lease. These are explained below:

(1) Finance Lease: Under finance lease all risks and rewards of ownership of asset are transferred to lessee. The ownership or title may or may not be transferred. A finance lease is somewhat like a hire purchase agreement. Under finance lease the lessee after paying agreed number of installments, is entitled to exercise an option to become the owner of asset.



Example:



Suppose the AB company takes a new automobile on lease for three year. Also assume that at the end of three years the AB company will be called to take the ownership of vehicle at no extra cost. Here not only the vehicle is taken on lease but also the AB company is using the lease agreement as a means of financing the automobile. This type of leasing is called capital lease or finance lease.

(2) Operating Lease: According to International Accounting Standard (IAS-17) the operating lease is one which is not a finance lease. Under operating lease, the lessor gives the right to lessee to use the asset or property for a specified period of time, but risks and rewards of ownership are retained by the lesser.



Example:



Let up suppose that MY enterprises owns a complete 6th floor in Eden Tower, a multi story building. Further assume that MY enterprises gives some rooms of this floor on lease to XY corporation.

Now if the value of this building increase due to good business activity then the lessor i.e., MY enterprises can take the benefit of this increase by either selling out the rooms or by increasing the rental amount. On the other hand if the building decreases in value than also the MY enterprises will be the sufferer of loss. This type of leasing is called operating lease.

Besides these two main types, some other types of leasing are explained below:

(3) Sale and Lease Back: Under sale and lease back agreement, an asset is first sold to the leasing company or financial institution. The sale is made at the genuine market value. After that the asset is taken back on a lease. This type of leasing is advantageous for those companies which do not want to show high debt balances in their financial statement.



(4) Capital Lease: This type of leasing is governed by the financial standard board which is not applicable in Pakistan. Under this type of leasing when lessee acquires an asset on lease, he simultaneously recognizes it as a liability in the financial statement.



(5) Leveraged Lease: This type of leasing involves three parties including a lender, a lessor and a lessee. The lender and lessor join hands to accumulate funds to buy the asset. The asset purchased is then given on the lease to lessee. The lessee makes periodic payments to the lessor who in turn makes payment to the lender.



(6) Cross Border Leasing: Cross border leasing means to operate lease agreement in other countries. Such type of leasing is very difficult in present circumstances. The reasons being that different accounting treatments, tax charges and incidental criteria prevail in foreign countries. Also the tax rules differ from country to country. So a big problem arises as how to present such lease agreement in financial statement.

However, as with recent developments the accounting treatments are being made similar for each items all-around the world by International Accounting Standards and it is hoped that cross border leasing will rapidly flourish in near future.

Arfan Ul Haq is an Asian Author. He writes articles about learn economics online, theories of economic growth and principles of macro economics.

 

[Swaswati Borpuzari]

Types and Examples of Leasing​

Leasing is a financial arrangement whereby one party (the lessor) provides an asset to another party (the lessee) for a specified period in exchange for periodic payments. This arrangement offers numerous benefits, including cost savings, flexibility, and the ability to access high-value assets without the need for a large upfront payment. Leasing can be categorized into several types, each with its own specific characteristics and applications. This article explores the main types of leasing and provides examples to illustrate how they work.

1. Operating Lease​

An operating lease is a short-term lease agreement where the lessee has the right to use an asset for a period shorter than the asset's useful life. The lessee does not take on the risks and rewards of ownership, and the asset is returned to the lessor at the end of the lease term. Operating leases are common for equipment, vehicles, and office space.

Example: A retail company leases a copier for its headquarters for a period of three years. The copier is expected to have a useful life of eight years. The lease agreement requires the company to make monthly payments, and at the end of the three years, the copier is returned to the leasing company. During the lease term, the lessor is responsible for maintenance and other services.

2. Finance Lease​

A finance lease (also known as a capital lease) is a long-term lease where the lessee effectively assumes the risks and rewards of ownership. The lessee is responsible for maintaining the asset and may have the option to purchase it at the end of the lease term for a nominal price. Finance leases are often used for high-value assets like aircraft, heavy machinery, and real estate.

Example: A manufacturing company leases a piece of industrial machinery for a period of 10 years. The machinery has a useful life of 12 years. The lease agreement requires the company to make quarterly payments, and at the end of the lease term, the company has the option to purchase the machinery for a small residual amount. The machinery is recorded on the company's balance sheet, and the lease payments are treated as a combination of interest and principal.

3. Sale and Leaseback​

A sale and leaseback arrangement involves the sale of an asset by the owner (the seller) to a leasing company, followed by the immediate leasing of the same asset back to the seller. This allows the seller to free up capital that was tied up in the asset while still retaining the use of it.

Example: A logistics company owns a fleet of trucks and decides to sell them to a leasing company. The leasing company then leases the trucks back to the logistics company for a period of five years. The logistics company uses the proceeds from the sale to invest in new technology and continues to use the trucks for its operations.

4. Leveraged Lease​

A leveraged lease is a complex arrangement that involves three parties: the lessor, the lessee, and a lender. The lessor borrows a portion of the purchase price of the asset from the lender and uses the loan to finance the asset. The lessee makes lease payments to the lessor, who uses a portion of these payments to pay off the loan.

Example: A construction company wants to lease a large crane. The lessor (a leasing company) purchases the crane and borrows 70% of the purchase price from a bank. The construction company makes lease payments to the leasing company, which uses these payments to pay the interest and principal on the loan. At the end of the lease term, the crane may be transferred to the construction company or returned to the lessor.

5. Sublease​

A sublease occurs when a lessee (the sublessor) leases an asset to a third party (the sublessee) during the term of its original lease. This is often done to reduce the lessee's financial burden or to align with operational needs.

Example: A startup company leases a large office space but finds that it has more space than it needs. The company subleases a portion of the office to another startup, which pays a portion of the original lease payments to the sublessor. This arrangement helps the original lessee manage its costs and utilize the space more efficiently.

6. Direct Lease​

A direct lease is a straightforward lease agreement between the lessor and the lessee. The lessor purchases the asset and leases it directly to the lessee, who makes periodic payments for the use of the asset. This type of lease is common in various industries, including automotive, real estate, and technology.

Example: A software development firm leases a server from a technology leasing company. The firm makes monthly payments for the server, which it uses to host its applications and data. The leasing company retains ownership of the server, and the firm does not have to invest in the high upfront cost of purchasing it outright.

7. Synthetic Lease​

A synthetic lease is a hybrid of a traditional lease and a loan. It is structured to provide the lessee with the benefits of both ownership and leasing. The lessee can keep the asset off its balance sheet while still enjoying tax benefits and other advantages of ownership.

Example: A hospital decides to expand its facilities but wants to avoid increasing its debt levels. The hospital enters into a synthetic lease agreement with a financial institution. The institution purchases the expansion equipment and leases it to the hospital. The hospital makes periodic payments, which are structured to be tax-deductible, and the asset is treated as an operating lease for accounting purposes.

8. Sale of Lease Receivables​

In a sale of lease receivables (also known as lease factoring), the lessor sells the future lease payments to a third party (the factor) at a discount. This provides the lessor with immediate cash flow and allows the factor to earn a return on the lease payments.

Example: A leasing company has multiple finance leases with various lessees. To improve its cash flow, the leasing company sells the future lease payments from these agreements to a financial institution. The financial institution pays a discounted amount to the leasing company and collects the lease payments directly from the lessees.

Conclusion​

Leasing is a versatile financial tool that can be tailored to meet the specific needs of businesses and individuals. Whether it's an operating lease for short-term use, a finance lease for long-term commitments, or a sale and leaseback to free up capital, each type of lease offers unique benefits. Understanding the different types of leases and their applications can help individuals and businesses make informed decisions about asset management and financial planning.

By leveraging the right type of lease, companies can optimize their resources, reduce financial risk, and focus on their core business activities. Whether you're a small startup or a large corporation, leasing can be a valuable strategy to enhance your operational efficiency and financial health.

 

[LekshmiGPilllai]

Thank you for this clear explanation on leasing! The breakdown between finance and operating leases, along with the examples, really helped clarify the concept. I especially found the part about sale and leaseback and cross-border leasing insightful—didn’t realize how strategic leasing could be in financial structuring. Looking forward to reading more from Arfan Ul Haq!