Lease

A lease is a contract wherein, over the term of the lease, the owner of the equipment permits another
entity to use it in exchange for a promise by the latter to make a series of payments. The owner of the
equipment is referred to as the lessor. The entity that is being granted permission to use the equipment is
referred to as the lessee. Most corporate financial executives recognize that earnings are derived from the
use of an asset, not its ownership, and that leasing is simply an alternative financing method. More
equipment is financed today by equipment leases than by bank loans, private placements, or any other
method of equipment financing. Nearly any asset that can be purchased can also be leased, from aircraft,
ships, satellites, computers, refineries, and steam-generating plants, on the one hand, to typewriters,
duplicating equipment, automobiles, and dairy cattle, on the other hand.
In order to compare leasing with other methods of financing, it is necessary to understand the basics of
how leasing works and the differences among the general categories of equipment leases.

HOW LEASING WORKS

A typical leasing transaction works as follows. The lessee first decides on the equipment needed. The
lessee then decides on the manufacturer, the make, and the model. After the equipment and terms have
been specified and the sales contract negotiated, the lessee enters into a lease agreement with the lessor.
The lessee negotiates with the lessor on the length of the lease; the rental; whether sales tax, delivery, and
installation charges should be included in the lease; and other optional considerations. After the lease has
been signed, the lessee assigns its purchase rights to the lessor, which then buys the equipment exactly as
specified by the lessee. When the equipment is delivered, the lessee formally accepts the equipment to
make sure it gets exactly what was ordered. The lessor then pays for the equipment, and the lease goes
into effect.
At the end of the lease term, the lessee usually has the option to renew the lease, to buy the equipment, or
to terminate the agreement and return the equipment. The options available to the lessee at the end of the
lease are very significant in that the dimensions of such options determine the nature of the lease and the
classification of the lease.

TYPES OF LEASE AGREEMENTS

Lease agreements are basically of two types. They are (a) Financial lease and (b) Operating lease (c)
Sale and Lease Back.
In countries covered by International Financial Reporting standards, the leasing is addressed in IAS 17.

(a) Financial lease

Long-term, non-cancellable lease contracts are known as financial leases. The essential point of
financial lease agreement is that it contains a condition whereby the lessor agrees to transfer the title
for the asset at the end of the lease period at a nominal cost. At lease it must give an option to the
lessee to purchase the asset he has used at the expiry of the lease. Under this lease the lessor recovers 90%
of the fair value of the asset as lease rentals and the lease period is 75% of the economic life of the asset.
The lease agreement is irrevocable. Practically all the costs of maintenance, insurance and repairs are

borne by the lessee. Only title deeds remain with the lessor. Financial lease is also known as capital
lease.

(b) Operating lease

An operating lease stands in contrast to the financial lease in almost all aspects. This lease agreement
gives to the lessee only a limited right to use the asset. The lessor is responsible for the upkeep and
maintenance of the asset. The lessee is not given any uplift to purchase the asset at the end of the lease
period. Normally the lease is for a short period and even otherwise is revocable at a short notice.
Mines, Computers hardware, trucks and automobiles are found suitable for operating lease because the
rate of obsolescence is very high in this kind of assets.

c) Sale and Lease Back

It is a sub-part of finance lease. 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. However, under this
arrangement, the assets are not physically exchanged but it all happens in records only. This is nothing
but a paper transaction. Sale and lease back transaction is suitable for those assets, which are not
subjected depreciation but appreciation, say land. The advantage of this method is that the lessee
can satisfy himself completely regarding the quality of the asset and after possession of the asset
convert the sale into a lease arrangement.

Reasons of leasing
Leasing is an alternative to purchasing. Because the lessee is obligated to make a series of payments, a
lease arrangement resembles a debt contract. Thus, the advantages cited for leasing are often based on a
comparison between leasing and purchasing using borrowed funds.
1. Conservation of Working Capital
The most frequent advantage cited by leasing company representatives and lessees is that leasing
conserves working capital. The reasoning is as follows: When a firm borrows money to purchase
equipment, the lending institution rarely provides an amount equal to the entire price of the equipment to
be financed. Instead, the lender requires the borrowing firm to take an equity position in the equipment by
making a down payment. The amount of the down payment will depend on such factors as the type of
equipment, the creditworthiness of the borrower, and prevailing economic conditions. Leasing, in
contrast, typically provides 100% financing since it does not require the firm to make a down payment.
Moreover, costs incurred to acquire the equipment, such as delivery and installation charges, are not
usually covered by a loan agreement. They may, however, be structured into a lease agreement. The
validity of this argument for financially sound firms during normal economic conditions is questionable.
Such firms can simply obtain a loan for 100% of the equipment or borrow the down payment from
another source that provides unsecured credit. On the other hand, there is doubt that the funds needed by a
small firm for a down payment can be borrowed, particularly during tight money periods. Also, some
leases do, in fact, require a down payment in the form of advance lease payments or security deposits at
the beginning of the lease term.

Risk of Obsolescence and Disposal of Equipment

When a firm owns equipment, it faces the possibility that at some future time the equipment may not be
as efficient as more recently manufactured equipment. The owner may then elect to sell the original
equipment and purchase the newer, more technologically efficient version. The sale of the equipment,
however, may produce only a small fraction of its book value. By leasing, it is argued, the firm may avoid
the risk of obsolescence and the problems of disposal of the equipment. The validity of this argument
depends on the type of lease and the provisions therein.

Flexibility and Convenience

In addition to the flexibility and convenience that may result from leasing due to fewer restrictions being
imposed on management, four other reasons are often cited for leasing. These reasons are characterized
by flexibility and convenience.

Tailor-Made Lease Payments

Lease payment schedules can sometimes be designed to meet the specific needs of the lessee. For
example, lease payments can be reduced or not scheduled during the period when the firm has its greatest
needs for working capital. Payments can be set higher during the later years of the lease and lower in the
earlier years, subject to Internal Revenue requirements. Although it may be possible to structure a term
loan in the same way, it is generally difficult to do so