Lease financing is one of the important sources of medium and long term financing where the owner of an asset gives another person, the asset against periodical payments. The owner of the asset is known as the lesser and the user of the asset is known as the lessee. The periodical payment made by the lessee to the lessor is called the lease rental.
Under lease financing, the lessee is given the right to use the asset but the ownership lies with the lessor and at the end of the lease contract, the asset is returned to the lessor or an option is given to the lessee either to purchase the asset or to renew the lease agreement.
Types of lease financing
This is where the lessor transfers substantially all the risks and rewards of ownership to the lessee for rentals. In other words, it puts the lessee in the same condition where the lessee would have been if the lessee purchased the asset.
Finance lease is classified into two phrases:
- Primary period
- Secondary period
Primary period: this is the non-cancellable period and in this period, the lessor recovers his total investment through lease rental and this period may last for indefinite period of time.
Secondary period: this period is also known as pepper corn. It is almost the same as the primary period but in this period the lease rental is much smaller than that of primary period.
Features of lease finance
- A finance lease is a device that gives the lessee the right to use an asset.
- The money charged by lessor on primary period of lease is pretty much sufficient to recover his/her investment.
- The lessee is responsible for the maintenance of asset.
This is also known as service lease, in this type of lease the risks and rewards incidental to the ownership of asset are not transferred by the lessor or the lessee. The term of such lease is much less than the economic life of the asset and thus the total investment of the lessor is not recovered through lease rental during the period of lease. In operating lease, the lessor usually provides advice to the lessee for repair, maintenance and technical know how of the leased asset.
Features of operating lease
- The lessor provides the technical know how of the leased asset to the lessee.
- Risk and rewards incidental to the ownership of asset are borne by the lessor.
- The lease term is much lower than the economic life of the asset.
Advantages of lease financing
To the Lessor:
- Assured regular income: the lessor get lease rental by leasing an asset during the period of lease which is an assured regular income.
- Benefit of tax: as ownership lies with the lessor, tax benefit is enjoyed by the lessor by way of depreciation of respect of leased asset.
To the lessee:
- Tax benefits: a company is able to enjoy the tax advantage on lease payments as payments can be deducted as a business expense.
- Cheaper: leasing is a source of financing which is cheaper than almost all sources of all the source of financing.
Disadvantages of lease financing
To the Lessor:
- Double taxation: sales tax may be charged twice; first at the time of purchase of assets and second at the time of leasing the asset.
- Unprofitable in case of inflation: lessor gets fixed amount of lease rental every year and they cannot increase this even if the cost of the asset goes up.
To the Lessee:
- Ownership: the lessee will not become the owner of the asset at the end of lease agreement unless he decides to purchase it.
- Compulsion: finance lease is non-cancellable and even if a company does not want to use the asset, lessee is required to pay the lease rentals.