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Leasing

Chapter # 04

Lease is a contract under which a lessor, the owner of the assets, gives right to use the asset to a lessee, the user of the assets, for an agreed period of time for a consideration called the lease rentals.Hence A lease contract is an agreement where

the owner conveys to the user the right to use an asset in return for a number of specified payments over an agreed period of timeLessor is the owner of the assetLessee is the user of the asset

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◦A lease is a contractual agreement between a lessee and lessor.

◦The agreement establishes that the lessee has the right to use an asset and in return must make periodic payments to the lessor.

◦The lessor is either the asset’s manufacturer or an independent leasing company.

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Operating Lease A lease where some of the benefits of ownership do

not transfer to the lessee and remain with the lessor.

Financial (Capital) Lease A lease where essentially all the benefits of

ownership transfer to the lessee; also known as a capital or full payout lease.

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Shot-term, cancelable lease agreements are

called operating lease.

Tourist renting a car, lease contracts for

computers, office equipments and hotel rooms.

The Lessor is generally responsible for

maintenance and insurance.

Risk of obsolescence remains with the lessor.

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Long-term, non-cancelable lease

contracts are known as financial lease.

Examples are plant, machinery, land,

building, ships and aircrafts.

Amortize the cost of the asset over the

terms of the lease–Capital or Full pay-out

leases.

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Lessee Lessor Lessee Lessor

Asset Not on balance sheet (B/S); disclose in footnotes

Report on B/S Report on B/S Not on B/S

Lease payments Expense the full amount as rental expense

Claim as rental income

Decompose into interest and principal repayment, and expense the interest portion

Claim the interest portion of payments received as interest income

Depreciation expense (associated with leased asset)

Cannot claim Claim Claim Cannot claim

Table 16-1 Operating versus Financial Leases

OPERATING FINANCIAL

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Sometimes, a user may sell an (existing) asset owned by him to the lessor (leasing company) and lease it back from him. Such sale and lease back arrangements may provide substantial tax benefits.

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The lessee is deemed to own the asset and will claim depreciation on the firm’s income statement and record the value as an asset and liability on the balance sheet.Such leases usually:

Require the lessee to carry out maintenance and insure the asset Provides the lessee with a fixed purchase option Involves fixed rental payments.

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• If a lease is NOT a capital lease, then it is an operating lease

• Operating leases do not transfer to the lessee the benefits of ownership

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• A three-way agreement among the lessee, the lessor, and a third party lender in which the lessor buys the asset with only a small down payment and the lender supplies the financing

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Financial leases are included on the balance sheet of the lessee

Operating leases are off-balance-sheet financing for the lessee (included only in the notes to the financial statements)

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