Lease Finance - Operating and Financial Lease
[Finance Notes for AHSEC Class 12 2026 Exam]
Q.1. What do you mean by lease? What
are its features?
Ans:
Meaning: Leasing is a contractual transaction in which the owner of an asset
(called lessor) gives the same to another party (called lessee) the right to
use it for a specified period of time (called lease period) in consideration of
certain payments (called lease rentals). The International Accounting Standard
No.17 (IAS - No.17) defines Leasing as “an agreement whereby the Lessor
conveys, to the lessee in return for rent, the right to use an asset for an
agreed period of time.”
Features of Leases:
a) The Parties: There are mainly two parties – lessor
and lessee.
b) The Asset: The subject of lease transactions is a
tangible asset.
c) The Agreement: Written lease agreement is not a legal
necessity. It is desirable to execute a written lease agreement when the period
is large and considerations complex.
d) The Period: The term of a lease is the period for which
the lease agreement will be in operation. When the lease period expires the
asset reverts back to the lessor.
e) The Rent: The lease rentals are the regular
fixed payments made by the lessee over a period of time at the beginning or at
the end of say a month, a quarter, a half-year or year.
f) The use: In a lease transaction, the lessee
(user) acquires only the usage or custody of the asset and is not the owner
thereof. Legal ownership vests with the lessor. As the legal owner, it is the
lessor not the lessee, who is entitled to claim depreciation of leased asset.
Q.2. What are various types of leases?
Mention their features.
Ans:
Types of Leases: Leasing is a unique type of commercial contract. Lease
financing is often termed as equipment leasing and it is broadly classified
into:
(a) Operating Lease: In operating lease, the lease is
usually for a shorter term and is generally cancellable. As the asset is
leasable repeatedly to several persons, the operating lease is usually said to
be a non-payout lease.
Features of operating leases
1. The lease contract is generally for a
period which is considerably shorter than the useful life of the leased asset.
2. The
lessor does not, therefore, recover the full cost of the asset from one lessee
only. The leased asset is returned back to the lessor at the end of the lease
period and is, thereafter, leased again to another lessee for another lease
period.
3.
Operating lease generally contains a cancellation clause also, wherein the
lessee retains the right to cancel the lease any time before the lease period
is over.
4. The lease agreement contains a
maintenance clause whereby the lessor is required to maintain the leased
assets. Thus, necessary repairs, fuel, support staff may be provided by the
lessor, as agreed upon.
(b) Financial Lease: Financial lease is a long-term lease
usually coinciding with the economic life of the asset and is non-cancellable.
It operates as a long-term debt financing and is usually full-payout as in
contrast to operating lease, it is usually a single lease repaying the cost of
the asset. They play a major role in financing of building of buildings and
equipments to industries.
Features of Financial lease
1. In case of Financial lease, the
asset is exclusively for the use of particular lessee.
2. The
lease period may stretch over the entire the economic life of the asset.
3. The
lessor is only a financier. usually he is not interested in the asset.
4. Lease
period is non-cancellable.
5. The
assets leased includes ships, aircraft, railway wagons, land, building, heavy
machinery etc.
(b) Service Lease: It is an equipment leasing system under
which the lessor provides financing as well as servicing of the assets during
the lease period. The lessor will covenant with the lessee to provide maintenance
and servicing of the leased asset during the existence of the lease.
Q.3. Distinguish between operating
lease and financial lease.
Ans:
Difference between operating lease and financial lease
|
Operating Lease |
Financial Lease |
|
It
is a short term concept. |
It
is a long term concept. |
|
The lease period is shorter than the
useful life of the asset. |
The lease period may stretch over
the entire the economic life of the asset. |
|
Ownership
of the asset remains with the lessor. |
Ownership
of the assets transferred to the lessee. |
|
In
operating lease, the lessee is not given any option to purchase the asset. |
In
financial lease, the lessee is given an option to purchase the asset. |
|
The lesser has ultimate interest in
the residual value of the asset. |
The lessor is only a financier.
usually he is not interested in the asset. |
Q.4. What
are the advantages and disadvantages of lease finance to lessor and lessee?
Ans:
Advantages of Lease Finance:
For Lessor:
1. Steady Income: Ensures a consistent cash
flow through regular lease payments.
2. Asset Retention: Retains ownership of the
leased asset, offering potential resale value.
3. Tax Benefits: Enjoys tax advantages,
including depreciation and interest deductions.
4. Risk Transfer: Shifts certain risks, such
as obsolescence, to the lessee.
5. Portfolio Management: Allows for a
diversified portfolio of leased assets.
For Lessee:
1. Capital Preservation: Requires minimal
upfront costs, preserving capital for other needs.
2. Flexibility: Customizable lease structures
provide flexibility to meet business requirements.
3. Access to Technology: Grants access to the
latest technology without the full purchase cost.
4. Tax Efficiency: Potentially benefits from
tax advantages by deducting lease payments.
5. Off-Balance Sheet Financing: Keeps leased
assets off the balance sheet, enhancing financial flexibility.
Disadvantages
of Lease Finance:
For Lessor:
1. Depreciation Risk: Faces the risk of asset
depreciation affecting resale value.
2. Maintenance Costs: May be responsible for
maintenance expenses as per lease terms.
3. Liquidity Impact: Ties up capital in
assets, potentially impacting immediate liquidity.
4. Market Fluctuations: Vulnerable to market
changes affecting the value of leased assets.
5. Legal and Regulatory Risks: Subject to
legal and regulatory challenges during the lease period.
For Lessee:
1. Total Cost: May pay more over time compared
to outright purchase.
2. Limited Ownership: Lacks ownership rights,
restricting modifications or resale.
3. Lease Obligations: Long-term commitments
may limit financial flexibility.
4. Dependency: Relies on lessor for
maintenance and service of the leased asset.
5. Obsolescence Risk: Faces the risk of using
outdated technology over time.
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