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Leasing is an old method of financing which is now becoming popular almost all over the world. Legally, a lease contract is not a sale of the item, but a sale of use (the right to use the item) for a specified period. Under this, there are two parties one is the owner or lessee of the asset and the other is the lessee or the party who takes the asset on lease. The lessee takes the asset for use for a specified period and pays rent. The asset is owned by the lessee but it is in the possession of the lessee and the right of use is also transferred to the lessee.
It has the following types. There are two basic types of leasing: finance lease and operating lease. These are explained below:
(1) Finance lease: Under finance lease all the risks and rewards of ownership of the asset are transferred to the lessee. The ownership or title may or may not be transferred. A finance lease is somewhat like a hire purchase agreement. Under a finance lease, the lessee is entitled to exercise the option to become the owner of the asset, after paying an agreed number of instalments.
Example:
Suppose company AB takes a new automobile on lease for three years. Assume also that at the end of three years AB Company will be called upon to take over the ownership of the vehicle at no additional cost. Here not only the vehicle is taken on lease but the AB company is using the lease agreement as a means of financing the automobile. This type is called capital lease or finance lease.
(2) Operating Lease: As per International Accounting Standard (IAS-17) operating lease is one which is not a finance lease. Under an operating lease, the lessee grants the lessee the right to use the asset or assets for a specified period of time, but the risks and rewards of ownership are retained by the lessee.
Example:
Let’s say MY Enterprises owns the entire 6th floor in a multi-storey building in Eden Tower. Suppose further that MY Enterprises leases some rooms on this floor to XY Corporation.
Now if the value of this building increases due to good business activity, then the lessee i.e. MY Enterprises can take advantage of this increase either by selling the room or by increasing the rental amount. On the other hand, MY Enterprises will suffer losses even if the value of the building depreciates. This type of leasing is called an operating lease.
Apart from these two main types, some other types of lease are given below:
(3) Sale and lease back: Under a sale and lease back agreement, a property is first sold to a financial institution. The sale is made at the actual market value. The asset is then taken back on lease. This type of leasing is beneficial for companies that do not want to show high debt balances in their financial statements.
(4) Capital Lease: This type of leasing is governed by the Financial Standards Board which is not applicable in Pakistan. Under this type, when the lessee acquires an asset under the lease, it simultaneously recognizes it as a liability in the financial statement.
(5) Leverage Strap: This type of lease involves three parties including a lender, a lessor and a lessee. The lender and the lessee join hands to raise funds to purchase the property. The purchased asset is given on lease to the lessee. The lessee makes periodic payments to the lessee who in turn makes payments to the lender.
(6) Cross Border Leasing: This means operating lease agreements in other countries. This type of leasing is very difficult in the present circumstances. The reason is that different accounting treatment, tax charges and relevant norms are prevalent in foreign countries. Also, tax rules differ from country to country. Therefore, a major problem arises as to how to present such lease agreement in the financial statement.
However, as with recent developments the accounting treatment for each item is being made uniform across the world by international accounting standards and it is expected that cross border leasing will grow rapidly in the near future.
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