Leasing Types

Finance Lease

Fixed-term (and usually non-cancelable) lease that is similar to a loan agreement for purchase of a capital asset on installments. The lessor’s services are limited to financing the asset, the lessee pays all other costs including insurance, maintenance, and taxes. Finance leases are regarded as essentially-equivalent to a sale by the lessor, and a purchase by the lessee (even though the title remains with the lessor). Therefore, leased assets must be capitalized and shown in the lessee’s balance sheet as a fixed asset with a corresponding non-current liability (lease payable).

The lessee acquires all the economic benefits (such as depreciation) and risks (such as the possibility of the loss of the leased asset) of ownership but can claim only the interest-portion (not the entire amount) of the lease payment as an expense. To be considered a finance lease, a lease must meet one or more of these main criteria:

• Title of the asset passes automatically from the lessor to the lessee at end of the lease term
• Lease contains a bargain purchase option under which the lessee may acquire the leased-asset at less than its fair market value at the end of lease term
• Lease term is for a period longer than the 75 percent of the estimated economic life of the asset
• The present value of the lease payments is greater than 90 percent of the fair market value of the asset at the beginning of the lease term.

A finance lease is a ‘full payment lease’ because the lease payments pay back (amortize) the full cost (including financing costs, overheads, and profit margin) of the leased asset to the lessor, with little or no dependence on the residual (or salvage) value of the asset.
Finance leases are reported by the lessee as if the assets being leased were acquired and the monthly rental payments as if they were payments of principal and interest on a debt obligation. Specifically, the lessee capitalizes the lease by recognizing an asset and a liability at the lower of the present value of the minimum lease payments or the value of the assets under lease. As the monthly rental payments are made, the corresponding liability decreases. At the same time, the leased asset is depreciated in a manner that is consistent with other owned assets having the same use and economic life

Operating Lease

Often with a shorter time frame than financial leasing (always significantly shorter than the working life of the asset), operating leasing is more like a regular rental. The lessor expects to be able to either sell the asset in the second-hand market or to lease it again and will therefore not need to recover the total asset value through lease payments. There may be an option to extend the leasing period at the end (this negotiation can only take place at the end of the initial rental period).

Sale and Leaseback

A sale and lease back transaction is a deal in which a company sells legally owned equipment to a leasing company and leases it back for a period acceptable to both parties. A sale and lease back enables businesses of all sizes – from small-to-medium enterprises to large corporations – to free up capital through the sale of assets at the written down or market value.

There are two key reasons for companies to consider a sale and leaseback transaction:

1. Liberate Capital
   Depending on the quality of the asset being sold, freeing up equity at good rates presents opportunities for companies to redeploy this capital into core business activities with higher rates of return, or to reduce higher cost of borrowings.
2. An alternative to conventional financing

Companies can investigate the potential for sale and leaseback transactions as an alternative to borrowing from more traditional sources. The feasibility of this will depend on where the investment yields currently sit in relation to the weighted cost of capital (internal) and external sources of finance.