Types of Finance Lease Agreements

A finance lease, also called a capital lease, is one which usually covers the full useful economic life of the assets or a period that is close to the economic life. The lessor receives lease rentals during the lease period so as to recover fully not only the cost of the assets but also a reasonable return on the funds used to buy the assets. The finance lease is usually a non-cancellable and the lessee provides for the maintenance of the assets. The lease payment under financial lease is a payment for the use of the assets only and the responsibility for the repair and maintenance of the assets generally lies with the lessee. Since the term of a finance lease is normally closely aligned with the economic life of the assets, the lessee’s position is quite similar that of an owner; and the cost of maintaining is in its hands. At the end of the lease period, the assets may be returned to the lessor or handled as per the lease contract.

From the point of the view of the lessee, the finance lease ensures him an uninterrupted use the assets. For him a finance lease is essentially a form of borrowing for the purpose of acquiring an asset. The lessor may not be involved in dealing with the assets. The lessee may select the assets according to his requirement, may even negotiate the price, the delivery schedule etc., with supplier and get the delivery also. The payment however, is made by the lessor to the supplier. This arrangement is concurrent to the signing of the lease contract. There may be different types finance lease depending upon how the lessee acquires the asset. Some of these are as follows:

1. Direct Lease

This is the most straight forward type of finance lease. The lessor itself purchases the asset and hands it over to the lessee. A manufacturer can also act as a lessor and can deliver the assets to the lessee under the lease agreement (instead of delivering under the sale agreement). In other words, the lessee will normally specifies the manufacturer, the model number and other relevant characteristics of the asset it wishes to lease and the lessor will procure for the lessee.

2. Leveraged Lease

A leveraged lease is an arrangement where the lessor borrows a portion of the purchase price from some lender/financial institutions. This loan is secured by the assets and the lease rentals. The loan is repaid out of the lease rentals either directly by the lessee or the lessor. The surplus (i.e., the difference between the lease rental and the repayment portion of it) then goes to the lessor. So, under the leveraged lease, the lessor acts as an equity participants supplying only a part of the cost of the assets and the lender supplies the balance. The lease rentals are distributed first to the lender to satisfy the scheduled debt service payments; any surplus then going to the lessor. If lease payments are less than the debt service, the lessor or the lessee (as the contract may provide for) will have to make up the difference. The lease payment must be large enough to meet the debt repayment, interest payment to the lender as well as provide a return to the lessor. The leveraged lease may generally be adopted in case of costly assets.

3. Sale and Lease Back

Under both the direct lease and the leveraged lease, the lessee acquire the assets after the lease arrangement. However, in case of sale and lease back, the situation is different. The lessee is already the owner of the assets. He, under the lease agreement, sells the assets to the lessor who, in turn, leases the assets back to the owner (now the lessee). Under the sale and lease back, the lessee not only retains the use of the assets but also gets funds from the ‘sale’ of the assets to the lessor. The sale and lease back is usually preferred by firms having fixed assets but shortage of funds. The sale and lease back agreement is essentially to help the lessee to mobilize the funds to tied over the liquidity position. In practice, it is a common type of lease arrangement. The tax provision relating to sale and lease back are:

  1. The asset is to be sold initially by the lessee to the lessor at the book value of the asset and not at the revalued figure.
  2. The lease rental payable by the lessee is allowed as deductible expense.
  3. Depreciation on the asset is available to the lessor on the basis of the book value of the asset, and
  4. The rental income will be taxable in the hands of the lessor.

About Abey Francis

Abey Francis is the founder of MBAKnol - A Blog about Management Theories and Practices - and he's always happy to share his passion for innovative management practices. You can found him on Google+ and Facebook. If you’d like to reach him, send him an email to: [email protected]

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