Meaning of Lease Financing: Commerce YouTube Lecture Handouts

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Topics to be covered are

  • Meaning Of Lease Financing
  • About Lease Financing
  • Importance of Lease Financing
  • Advantages of leasing
  • Disadvantages of Leasing
  • Types of lease Agreements
  • Operating Leverage
  • Financial Lease
  • Difference Between Operating Lease and Financial lease
  • Sale and Lease Back

Meaning of Lease Financing

A lease transaction is a commercial arrangement, whereby an equipment owner or manufacturer conveys to the equipment user the right to use the equipment in return for a rental.

History of Lease Financing

  • Leasing was introduced in the United States of America during 1940s and 1950s. It is estimated that leasing industry in the USA finances about 25 per cent of capital goods acquisition. The concept of leasing was pioneered in India by the SPIC group which established “First Leasing Company of India Limited” in 1973 at Chennai.
  • Later on 20th Century Leasing Company Limited was set up in Mumbai. Now, IFCI, IDBI, ICICI, State Bank of India, SIDCs, Sundaram Finance and other entities are running leasing companies in our country.

Importance of Lease Financing

  • Leasing industry plays an important role in the economic development of a country by providing money incentives to lessee
  • The lessee does not have to pay the cost of asset at the time of signing the contract of leases.
  • Leasing contracts are more flexible.
  • The lessee can also pass on the risk of obsolete to lessor.
  • Leasing of houses, apartments, offices, etc. are familiar to most of us.

Advantages of Leasing

  • Leasing covers the full cost of the equipment used in the business by providing 100 % finance.
  • The lease agreement can be tailor made in respect of lease period and lease rentals according to the convenience and requirements of all lessees.
  • Leasing enables the lessee to plan its cash flows properly.
  • Leasing enables the lessee to improve their liquidity position by adopting the sale and lease back technique.
  • Leasing saves time as the asset is available for use immediately.
  • Lease rentals are deductible from taxable income.

Disadvantages of Leasing

  • The lessee gets only the right to use the asset.
  • The lessee cannot make alterations or improvements in the asset without the prior approval of the lessor.
  • The lessee has to pay lease rentals on a regular basis to the lessor.

Types of Lease Agreements

Lease agreements are basically of two types. They are

  • Financial lease
  • Operating lease

Operating Lease

Operating lease is a contract wherein the owner, called the Lessor, permits the user, called the Lessee, to use of an asset for a particular period which is shorter than the economic life of the asset without any transfer of ownership rights. The Lessor gives the right to the Lessee in return for regular payments for an agreed period of time.

Features of Operating Leverage

  • Operating leases typically require the lessor to maintain and service the leased equipment.
  • Operating lease are not fully amortized.
  • The lease contract is written for a period considerably shorter than the expected useful life of the leased asset
  • There is a cancellation clause that gives the lessee the right to cancel the lease and return the equipment to the less or before the lease expires.

Financial Lease

  • The Finance Lease or Capital Lease refers to the agreement wherein the lessee gets the ownership of the asset before the lease expires. Simply, the finance lease is the type of lease wherein the lessor transfers all the risks and rewards associated with the asset to the lessee before the lease agreement expires.
  • Financial leases are different from operating leases as they
    • Typically do not provide for maintenance
    • Typically are not cancelable
    • Are generally for a period that approximates the useful life of the asset and hence
    • Are fully amortized

Difference between Operating Lease and Financial Lease

Difference between Operating Lease and Financial Lease
Aspects of DifferenceOperating LeaseFinancial Lease
(1) DEFINITIONA lease in which all risks and rewards related to asset ownership remain with the lessor for the leased asset is called an operating lease.In a financial lease (also known as a capital lease) , the risks and rewards related to ownership of the asset being leased are transferred to the lessee.
(2) OwnershipWith the lessorTransfer option at the end of the lease period is there with the lessee.
(3) Risk And RewardsWith the lessorWith the lessee
(4) Expenses BorneBy lessorBy lessee
(5) Running Cost To LesseeNo running or administration costsRunning cost and administration cost are higher and borne by lessee.
(6) PURCHASE OPTIONDoes not have any optionThe lessee have a purchase option
(7) TAX BENEFIT TO LESSEENo depreciation can be claimedInterest and depreciation both claimed
(8) LEASE TERMThe lease term extends to less than 75 % of the projected useful life of the leased asset.The lease term is generally the substantial economic life of the asset leased.
(9) EXAMPLEProjectors, Computers, Laptops, Coffee Dispensers, etc.Plant and Machinery, Land, Office Building, etc.

Sale and Lease Back

  • Under this, the owner of an asset sells the asset to a party (the buyer) , who in turn leases back the same asset to the owner in consideration of lease rentals.
  • Under this transaction, the seller assumes the role of a lessee and the buyer assumes the role of a lessor. The seller gets the agreed selling price and the buyer gets the lease rentals. It is possible to structure the sale at agreed value (below or above the fair market price) and to adjust difference in the lease rentals. Thus, the effect of profit/loss on sale of assets can be deferred.