Even though term of Leasing often used by most of people, but actually only limited people who really understand the definition and role of leasing, especially equipment leasing. Leasing transaction is considered as a quite complex transaction in term of tax and accounting. Even daily practitioner sometimes get into some confuses and cause additional cost for their lessee due to it’s complexity. Moreover, different country usually has different legal and tax regulation related to leasing, so that leasing practice in one  country may not be valid in other country.

Even though there are some complexities in practice, but basically leasing has similar nature regardless prevailed regulation in any country. Basically, leasing transaction can be separated into two main categories: financial leases and operating leases. Financial lease represents a longer term lease commitment in which the sum of the rents due will approximate the equipment’s purchase cost plus profit of the lessor (full pay out). Meanwhile, all lease transaction which is not fitting with the financial lease can be put into operating lease category.

Within the two broad categories, are some basic variations. The most popular variation in major Asian countries is  leverage lease, beside other service lease and non leveraged lease. These variations are sometimes incorrectly considered to be separate types of leases rather than descriptive forms of the basic types. For example, finance leases can be leveraged leases or non leveraged leases, and service leases can be financial or operating in nature.

This posting will briefly explain three of leasing categories, ie financial lease, operating lease, and leveraged lease.

1. Financial Lease

Financial leases are considered long term leases because the primary lease terms usually run for most of the equipment’s useful life. Typically, the total cash flow over the term—from rents, tax savings, and the end-of-lease equipment (residual) resale or re-lease value—will be sufficient to pay back the lessor’s investment, take care of the administrative expenses, pay off any equipment-related debt obligations and commissions, and provide a profit (full pay out).

Because they are entered into by lessors as long-term financial commitments, finance lessors usually impose a substantial repayment penalty for a lessee’s early lease termination in an amount that will assure the lessor of a return of its investment and a profit, at least up to the date of termination.

Under financial lease, the fundamental ownership responsibilities, such as maintaining and repairing the equipment, paying for the necessary insurance, and taking care of property, use, and sales taxes, are placed on the lessee. So, financial lease can be compared with loan in that the lessor, like a lender, is involved only in asset funding.

In financial lease, lessee bears a major risk of lease item obsolescence, so that common lease item in financial lease are the items which has quite significant resale value compared with it’s brand new price.

2. Operating Lease

When full pay out condition is not fulfilled in lease transaction, the lease is called an operating lease. Operating lease can be span a few months to a few years, although some are as short as a few hours.

Because the lease terms are relatively short, an operating lessor usually cannot earn much of its equipment investment back through the rents from one lease transaction; thus, it must either sell or re-lease the equipment on attractive terms to be profitable.

Their short lease terms and easy cancellation provisions make operating lease attractive to users in several situations, especially if the user has planning to use the lease item in short period only. For this kind of transaction, it seems similar with rental transaction.

Other benefit for using operating lease to lessee is if residual value of item is very much depreciated or the item is related to fast changing technology. By using operating lease, the risk of obsolescence is born by lessor instead of lessee. So that, lease rent of operating lease is usually higher compared with financial lease.

3. Leveraged Lease

Both financial lease and operating lease can use this kind of variation. In a leveraged lease, lessor only cover some major percentage of purchase amount, let say 60% up to 80% of it. This leveraging generally enables lessor to provide a lessee with relatively lower rents while at the same time maintaining its return.

This kind of lease transaction is commonly used in Asian countries. Since the country risk is considered higher compared with other developped countries, lessor only take some portion of financing, and lease term will be set for shorter period (usually 3 years only). As consequence, credit risk will be lower and lease rent doesn’t reduced significantly due to shorter lease term.

There are a lot of variation of lease transactions, but in basic those three lease categories already covered the definision of leasing.

Tags: lease, Leasing

If you enjoyed this post, make sure you subscribe to my RSS feed!