Lease types and examples

Leasing is an ancient method of financing that is now gaining popularity almost everywhere in the world. Legally, the lease is not a sale of the thing, but a sale of usufruct (the right to use the thing) for a certain period of time. According to him, there are two parties, one is the owner or lessor of the asset and another is the lessee or the party taking the asset on lease. The lessee takes the asset for its use for a specified period of time and makes rental payments. Ownership of the asset remains with the lessor but is in the possession of the lessee and the right of use is also transferred to the lessee.

It has the following are different types. The two basic types of lease are: finance lease and operating lease. These are explained below:

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

Example:

Suppose Company AB leases a new car for three years. Suppose also that at the end of the three years Company AB will be called in to take over the vehicle at no additional cost. In this case, not only is the vehicle leased, but AB also uses the lease as a means of financing the car. This type is called a capital lease or finance lease.

(2) Operating lease: According to the International Accounting Standard (IAS-17), the operating lease is one that is not a financial lease. Under an operating lease, the lessor grants the lessee the right to use the asset or property for a specified period of time, but the lessor retains the risks and rewards of ownership.

Example:

Let’s assume that MY companies owns an entire sixth floor in Eden Tower, a multi-story building. Also, suppose that MY Corporation leases some rooms on this floor to XY Corporation.

Now, if the value of this building increases due to good business, then the landlord, ie MY companies, can benefit from this increase by selling the rooms or increasing the rent amount. On the other hand, if the value of the building decreases, also the MY companies will suffer losses. This type of lease is called an operating lease.

In addition to these two main types, other types of leases are explained below:

(3) Sale and leaseback: Under the sale and leaseback contract, an asset is first sold to the financial institution. The sale is made at real market value. After that, the asset is recovered in a lease agreement. This type of leasing is advantageous for those companies that do not want to show high debt balances in their financial statements.

(4) Capitalizable lease: This type of lease is governed by the financial regulations board which is not enforced in Pakistan. Under this type, when the lessee acquires an asset under lease, he simultaneously recognizes it as a liability in the financial statement.

(5) Leveraged lease: This type of lease involves three parties, including a lender, a lessor, and a lessee. The lender and the lessor come together to accumulate funds to purchase the asset. The purchased asset is then delivered in the lease to the lessee. The lessee makes periodic payments to the lessor, who in turn makes payments to the lender.

(6) Cross-Border Leasing: Means operating lease in other countries. This type of lease is very difficult under the current circumstances. The reasons are that different accounting treatments, tax charges and incidental criteria prevail in foreign countries. Also, tax rules differ from country to country. Then a big problem arises how to present such a lease in the financial statements.

However, as with recent developments, accounting treatments are being made similar for every item around the world by International Accounting Standards and cross-border leasing is expected to flourish rapidly in the near future.