Finance Lease and Operating Lease

Finance Lease

According to the International Accounting Standards (IAS-17), in a finance lease the lessor transfers, substantially all the risks and rewards incidental to the ownership of the asset to the lessee, whether or not the title is eventually transferred. It involves payment of rentals over an obligatory non-cancellable lease period, sufficient in total to amortise the capital outlay of the lessor and leave some profit. In such leases, the lessor is only a financier and is usually not interested in the assets. It is for this reason that such leases are also called full payout leases, as they enable a lessor to recover his investment in the lease and derive a profit. Types of assets included under such leases are ships, aircraft, railway wagons, lands, buildings, heavy machinery, diesel generating sets and so on.

The IAS-17 stipulates that a substantial part of the ownership related risks and rewards in leasing are transferred when:

(i) The ownership of the equipment is transferred to the lessee by the end of the lease firm: or

(ii) The lessee has the option to purchase the asset at a price that is expected to be sufficiently lower than the fair market value at the date the option becomes exercisable and if at the inception of the lease it is reasonably certain that the option will be exercised; or

(iii) The lease term is for a major of the useful life of the asset: the title may be eventually be transferred. The useful life of an asset refers to the minimum of its (i) physical life in terms of the period for which it can perform its function. (ii) technological life in the sense of the period in which it does not become obsolete and (iii) product market life defined as the period during which its product enjoys a satisfactory market. The criterion cut-off point is that if the lease: term exceeds 75 percent of the useful life of the equipment, it is a finance lease or

(iv) The present value of the minimum lease payment is greater than or substantially fair market value of the asset at the inception of the or eventually transferred. The cut-off point is that the present value exceeds 90 per cent of the fair market value of the equipment. The present value should be computed by using a discount rate equal to the rate implicit in the lease, in the case of the lessor, and the incremental rate in the case of the lessee.

According to the Accounting Standard (AS)-19: Lease issued by the Institute of Chartered Accountants of India (ICAI) in .January 2001, the classification of lease is based on the extent to which risks and rewards incidental to ownership of a leased asset lie with the lessor or the lessee. Risks include the possibility of losses from the idle capacity or technological obsolescence and of variation in return due to changing economic conditions. Rewards may be represented by the expectation of profitable operation over the economic life of the asset and of gain from appreciation in the value of the residual value that has been realized.

Indicators of situations, that individually or in combination, could also lead to a lease being classified as a finance lease are:

(a) If the lessee can cancel the lease, the lessor losses associated with the cancellation are borne by the lessor.
(b) Gains or losses from the fluctuation in the fair value of the residual fall to the lessee (for example in the form of a rent rebate equaling most of the sales proceeds at the end of the lease) and
(c) The lessee can continue the lease for a secondary period at a rent that is substantially lower than market rent.

Lease classification is made at the inception of till lease. If at any time, the lesser and the lessor agree to change the provisions of the lease, other than by renewing the lease, in a manner that would have resulted in a different classification of the lease under the criteria outlined above, or had the dunged terms been in effect at the inception of the lease, the revised agreement is considered as a new agreement over its revised term. Changes in estimates (for example, changes in estimate of the economic life or of the residual value of the leased asset) or changes in circumstances (for example, default by the lessee), however, do not give rise to a new classification of a lease for accounting purposes. A finance lease is structured to include the following features:

(i) The lessee (the intending buyer) selects the equipment according to his requirements, from its manufacturer or distributor:

(ii) The lessee negotiates and settles with the manufacturer or distributor, the price the delivery schedule, installation terms of warranties, maintenance and payment and so on;

(iii) The lessor purchases the equipment either directly from the manufacturer or distributor (under straight forward leasing) or from the lessee, after the equipment is delivered (under sale and lease back);

(iv) The lessor then lease out the equipment to the retains the ownership while lessee is allowed to use the equipment:

(v) A finance lease may provide a right or option to the purchase equipment at a future date. However, this practice is rarely, found in India.

(iv) The lease period spreads over the expected economic life of the asset. The lease is originally for a non-cancellable period called the primary lease period during which the lessor seeks to recover his investment along with some profit. During this period, cancellation of lease is possible only at a very heavy cost. Thereafter, the lease is subject to renewal for the secondary lease period during which rentals are substantially low;

(vii) The lessee is entitled to exclusive and peaceful use of the equipment during the entire lease period, provided he pays the rentals and complies with the terms of the lease;

(viii) As the equipment is chosen by the lessee, the responsibility of its suitability, the risk of obsolescence and the liability for repair, maintenance and insurance of the equipment rest with the lessee.

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