Lease Financing and Types of Lease Agreements with Advantages of Leasing

The funds required for capital investment are to be raised.
The term capital investment includes investment in fixed assets such as…
1) Land & building
2) Plant & Machinery
3) Other fixed assets
The expenditure in capital assets is a sunken investment.
An alternative to own & use the capital assets is to get them on lease & use
them as per the terms of the leasing agreement.
A contract of lease may be defined as a contract whereby the owner of an
asset (lesser) grants to another party (lessee) the exclusive right to use the
asset usually for an agreed period of time in return for the payment of rent.
The two important rights to the property….
1) Right to own
2) Right to use
 Important steps involved in a leasing transaction…
1) The asset required & determines the manufacturer or the supplier.
Requirements of lessee
a) The design specifications b) The price c) Warranties
d) Terms of delivery e) Installation & servicing
2) Lease agreement
a) The basic lease period
b) The timing & amount of periodical rental payments
c) Details of any option to renew the lese or to purchase the asset at the
end of the basic period.
d) Details regarding the responsibility for payment of cost of
maintenance & repairs, taxes, insurance & other expenses.
Net Lease Agreement – The lessee pays all these costs.
Maintenance Lease Agreement – The lesser maintains the asset &
also pays for the insurance.
3) The manufacturer / supplier to supply the asset has been delivered, tested
& accepted by the lessee.

Types of Lease Agreements
 Capital Lease
A capital lease is a long term arrangement, which is irrevocable during its
primary lease period.
1) The lesser transfer title to the lessee at the end.
2) The lease contains an option to purchase the asset at a bargain price.
3) The lease period is equal to or greater than 75 % if the estimated economic
life of the asset.
4) The present value of the minimum lease payments equals or exceeds 90 %
of the fair value of the leased property to the lesser.
The lessee has also to bear costs of insurance, repairs & maintenance of the
asset & other related expenses.
The capital lease – Close end lease.
 Operating Lease
The right to use the leased property for a limited period of time.
The lesser is responsible for the maintenance of the asset, insurance and al
other relevant expenditure.
An operating lease is generally preferred in the following circumstances…
1) Sale & Lease back
A firm sells an asset to another person who in turn leases it back to the firm.
The lessee gets immediate cash, which results in improvement in his cash flow
position.
The lesser gets the benefit in terms of tax credit due to depreciation.
2) Leveraged Leasing
This form a leasing has become very popular in recent years.
This type of lease agreement is used for financing those assets, which require
large capital outlays.
Involves three parties the lessee, the lesser and lender.

Advantages of Leasing
1) Permits alternative use of funds.
2) Arranges faster and cheaper credit.
Acquisition of assets under a leasing arrangement is cheaper & faster as
compared to acquisition of assets through any other source.
3) Increases lessee’s capacity to borrow.
Lessee to utilize more of his funds for working capital purposes.
4) Protects against obsolescence.
The lessee can protect himself against the risk of obsolescence by entering into
operating lease arrangements.
5) Boo for small firms.
6) Absence of restrictive covenants.
7) Trading on tax shield.
When a tax paying lesser owns the asset, he generally passes a part of the tax
benefit to the lessee by means of lower rental charges.
8) Invisible privileges.
The lessee gets a right to use the asset without owing it.

Disadvantages of Leasing
1) Deprived of ownership.
The lessee does not get the ownership of asset. He gets only a right to use.
2) Deprivation of the asset in case of default.
In case the lessee makes a default in rental payments, the lesser is entitled to
take over the asset & the lessee has no right to prevent.
3) No protection against supplier’s warranties.

Choice of Lesser
Now days any asset can be obtained on lease, from a transport vehicle to
heavy industrial equipment.
It is the perception & capability of both the lesser & the lessee which can make
leasing agreement to work effectively as a source of modern business finance...
1) Comparative market rate
The lessee must ensure that comparisons are made on the basis of rentals with
or without stamp duty.
2) Supply of correct information.
The lessee must give a full & accurate description of the equipment to be
purchased to avoid any complications & delay in settlement with the lesser.
The lesser should also provide all information regarding the asset proposed to
be leased which may be of interest of the lessee.
3) Service quality.
The liability of maintaining the leased asset rests with the lesser.
4) Financial strength.
The lesser should be a person of sufficient financial means required for
absorbing market fluctuations.
5) Professional skills
Leasing business requires specialized professional skill.
Lesser should be a person who can….
a) Explain to the lessee all legal aspects involved in the leasing transaction.
b) Structure the lease rentals
c) Advise the lessee regarding the period over which capital cost will be
Recovered.
6) Proper documentation
Documentation is extremely important & particularly when long term period is
involved.

Account for Leases
1) Discloser regarding lease transactions should be made at all in the financial
statements of the lesser and the lessee.
2) In case the disclosure is made in the financial statements, whether it should
be shown only by way of a footnote or should it form an integral part of the
annual accounts.
3) In case, Lease transactions form an integral part of the financial statements,
how it should be treated in the books of the lesser and the lessee.

IAS – Accounting for Leases
1) Lease
An agreement where by the lesser can convey to the lessee in return for
rent the right to use an asset for an agreed period of time.
2) Finance Lease
A lease, which transfers substantially all the risks & rewards incidental to
ownership of an asset.
3) Operating Lease
A lease other than the Finance Lease.
4) Minimum Lease Payments
The payment over the lease term that the lessee is or can required making
together with…
5) Face value
The amount for which as asset can be exchanged between a
knowledgeable willing buyer and a knowledgeable willing seller in an arm’s
length transaction.
6) Inception of the Lease
The earlier of the date of lease agreement or of a commitment by the parties
to the principal provisions of the lease.