FINANCIAL LEASING: CHARACTERISTICS, TYPES AND EXAMPLE - DUDAS - 2025

The leasing is a method used by a company to acquire assets with structured payments over time. It can be expressed as an agreement in which the landlord receives lease payments to cover the costs of the property.

A finance lease is similar to a full purchase transaction, which is financed through a term loan, in that payments are made monthly. The lessee not only has operational control over the asset, but also has a substantial part of the economic risks and benefits of the change in valuation of the asset.

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However, unlike a full purchase transaction, the lessee presents the balance due as debt, shows the payments as expenses, and does not have title to the equipment.

During the lease period, the finance company is considered the legal owner of the asset.

Importance for companies

Leasing is an important concept in business. Startups or small businesses are often looking for financial leasing options.

This is because their resources are limited and the owners of these companies do not want to invest so much money in acquiring assets to support the business from the beginning. That is why they lease the assets when they require it.

A monthly payment, even with the interest attached, is usually the best option, rather than using the cash to buy capital items.

Because bank financing remains elusive for many small businesses, financial leasing is a viable but poorly understood alternative.

There are many businesses that are failing due to cash flow problems. Some of those businesses may even be profitable, but their cash is tied up in inventory or accounts receivable. Financial leasing is an alternate line of credit that allows for greater liquidity.

It allows the lessee to buy an expensive item or capitalize the business over a period, thus alleviating the need to find a significant amount of cash up front.

Characteristics of the finance lease

The financial lease is a commercial agreement whose main characteristics are:

- The lessee, who will be the client or borrower, will select an asset, such as a computer, vehicle, software, etc.

- The lessor, which is the finance company, will buy that asset.

- The lessee will have the right to use that asset during the lease agreement.

- The lessee will pay a series of rents or fees for the use of that asset.

- The lease rent collected by the lessor during the primary period of the lease will be sufficient to recover a large part or all of the cost of the asset, plus the interest on the rentals paid by the lessee.

- The lease rent for a secondary period is much lower. This is often known as renting peppercorns.

- The lessee has the option to acquire ownership of the asset. For example, when paying the last rent at the purchase price of the trade option.

- The lessor assumes neither the risks nor the benefits derived from the use of the leased assets.

- This type of lease is not cancellable. The lessor's investment is insured.

Impact on accounting

A finance lease has financial characteristics similar to those of purchase contracts, since the usual result is that the lessee becomes the owner of the asset at the end of the lease,

However, it has different accounting treatments and tax implications. There may be tax benefits for the lessee, by leasing an asset rather than buying it. This can be a great motivation for obtaining a finance lease.

When capitalized, a finance lease leads to an increase in assets, as well as liabilities on the balance sheet. Working capital decreases as a consequence, but additional leverage is created by the increase in the debt-to-equity ratio.

In a statement of cash flow, part of the lease payments are reported under operating cash flow and part in financial cash flow, since finance lease expenses are allocated between capital expenses and interest, similar to a loan or bond.

Types

Capital or finance lease

It is a long-term agreement that cannot be canceled. The obligation of the lessee is to pay the rent of the lease until the expiration of the agreed period. The period of the lease generally corresponds to the operating life of the asset in the company.

It is a long-term lease in which the lessee must record the leased item as an asset on its balance sheet and record the present value of the lease payments as debt.

Additionally, the lessor must record the lease as a sale on its own balance sheet. A capital lease can last several years and is not cancellable. It is treated as a sale for tax purposes.

Operating lease

The operating lease term is short and can be terminated at the lessee's option, with prior notice.

Therefore, the operating lease is also called an "open-ended lease agreement." The lease term is shorter than the economic life of the asset. Consequently, the lessor does not recoup its investment during the primary lease period.

Some examples of operating leases are leasing of copying machines, computer hardware, automobiles, etc.

A company that knows the possible obsolescence of high-tech equipment may not want to buy any equipment. Instead, you will prefer to opt for an operating lease to avoid the potential risk of obsolescence.

Sale and lease

It is a subset of the finance lease. In this type of lease, a company sells an asset to another party, which in turn leases it to the company.

The asset is generally sold at market value. Therefore, the company receives the sale price in cash on the one hand, and on the other, receives the economic use of the asset sold.

The company is obliged to make periodic rent payments to the landlord. The sale and lease agreement is beneficial to both the lessor and the lessee.

While the former obtains tax benefits due to depreciation, the latter has an immediate cash inflow that improves its liquidity position.

In fact, such an arrangement is popular with companies facing a short-term liquidity crisis. However, under this arrangement, the assets are not physically exchanged, rather everything happens only in the records. It is nothing more than a paper transaction.

Leveraged lease

It is a special form of leasing that has become very popular in recent years. It is popular in financing high-value assets such as airplanes, oil rigs, and rail equipment.

In contrast to the three types of leasing mentioned above, in this case there are three parties involved: the tenant, the landlord, and the lender.

Leveraged leasing can be defined as a leasing arrangement in which the lessor provides a portion of the equity (for example, 25%) of the cost of the leased asset and the third-party lender provides the remainder of the financing.

The lessor, who is the owner of the asset, is entitled to the depreciation allowance associated with the asset.

Financial lease contract

It is a contractual arrangement in which the lessor, who is the owner of an asset, allows the lessee to use the asset for a specified period, in exchange for periodic payments.

The object of the lease can be vehicles, machinery or any other asset. When the lessor and the lessee agree on the terms of the lease, the lessee obtains the right to use the equipment. In return, you will make periodic payments for the duration of the lease.

However, the lessor retains ownership of the asset and has the right to cancel the equipment lease if the lessee violates the terms of the agreement or engages in illegal activity using the equipment.

Benefits

- Establish the amount and periodicity of payments.

- Minimum cost in advance.

- Rent is generally deductible from corporate taxes.

- Potential to continue using the asset at the end of the lease period.

- Additional financing line that may not affect the main banking agreements.

Responsibility for the maintenance of the asset

While in possession of the asset in a finance lease, the lessee will be responsible for maintaining the asset and for any services that may be required. It may be possible to make a separate maintenance contract.

It is important to make sure you have an insurance policy for the asset in question, which covers all potential damages that could arise during the course of the lease.

End of the contract

At the end of the finance lease, the opportunity may be given to extend the lease or return the asset to the finance company. This will depend on the terms of the agreement.

In most cases you will find that at the end of the primary tenancy period you will have the option to extend the lease to a secondary period.

This can continue indefinitely, ending when the lessor and lessee agree, or when the asset is sold.

The secondary lease can be much lower than the primary rent, or the lease can continue month by month with the same rent.

If no extension is required, the asset will be returned to the finance company, which will normally sell it.

Differences with the operating lease

Meaning

A finance lease is a commercial contract in which the lessor lets the lessee use an asset in exchange for periodic payments over a commonly long period. Therefore, it is a long-term concept.

An operating lease is a commercial contract where the lessor allows the lessee to use an asset in exchange for periodic payments for a short period of time. Therefore, it is a short-term concept.

Transferability

In a finance lease, all risks and rewards of ownership of the asset are transferred to the lessee.

This means that the lessee is in a position quite similar to having purchased the asset.

The lessor retains ownership of the asset, but the lessee obtains exclusive use of the asset.

In contrast to a finance lease, an operating lease does not transfer the risks and rewards of ownership to the lessee.

Nature of the contract

A finance lease is called a loan agreement / contract. The contract for an operating lease is called a rental agreement / contract.

After the contract is signed by both parties, the finance lease generally cannot be canceled. With the operating lease, even after the agreement between the two parties is signed, it can be canceled during the primary period.

Maintenance

In the case of financial leasing, the lessee is responsible for caring for and maintaining the asset. With an operating lease, the lessor is the one who cares for and maintains the asset.

Obsolescence risk

For financial leasing, this risk falls on the lessee. For the operating lease, this risk falls on the lessor.

Accounting management

A finance lease is a lease that must be recorded in the accounting system.

On the other hand, the operating lease is a concept that does not need to be recorded in any accounting system. That is why the operating lease is also called "off the balance sheet."

Tax advantage

A finance lease offers the lessee a tax deduction for asset expenses, such as depreciation and finance charges.

The operating lease offers a tax deduction only for rent payments.

Purchase option

In finance leasing, the lessee is given an option to purchase the asset at the end of the contractual period. In the operating lease, the lessee is not given such an offer.

Finance lease example

Company C is dedicated to the manufacture of bicycles. It has leased some specialized production equipment from the L.

The useful life of the equipment is 6 years and the lease term is five years. The fair value of the equipment is $ 20 million and the present value of the minimum lease payments made by Company C is $ 15 million.

The equipment is designed specifically for Company C's operations and the lease contains a provision that allows Company C to extend the lease at much lower rates, or to purchase the equipment at the end of five years for $ 1 million.

The fair value of the equipment at the end of the lease term is expected to be $ 4 million. This is definitely a finance lease as indicated by the following:

- The lease term is more than 70% of the useful life of the equipment;

- The lease contains an offer purchase option.

- The equipment is personalized and cannot be used by third parties without significant modifications.

References

1. Wikipedia, the free encyclopedia (2018). Finance lease. Taken from: en.wikipedia.org.
2. Maxxia (2018). How to tell the difference between a finance lease and an operating lease. Taken from: maxxia.co.uk.
3. Wall Street Mojo (2018). Financial Lease vs Operating Lease. Taken from: wallstreetmojo.com.
4. International Financial Reporting Tool (2018). Financial Lease. Taken from: readyratios.com.
5. DK Sinha (2018). Finance Lease: 4 Types of Lease Financing - Explained! Your Article Library. Taken from: yourarticlelibrary.com.
6. Accounting Explained (2018). Finance Lease. Taken from: accountingexplained.com.
7. Maxxia (2018). Finance Lease Explained. Taken from: maxxia.co.uk.
8. CFI (2018). What is an Equipment Lease Agreement? Taken from: corporatefinanceinstitute.com.