Types of Leases

A lease is an important method of financing in a business. It is one of the important sources of medium-and long-term financing where the owner of an asset gives another person the right to use that asset in exchange for periodical payments. There are two types of leases, which are based on how risks and rewards are shared between the lessee and the lessor, the lease period, and number of parties involved.

1) Finance Lease

A financial lease is a type of lease in which the lessor transfers all the risks and rewards to the lessee in exchange for lease rentals. This puts the lessee in the same condition as he would have been if he or she had bought the asset. This type of lease non-cancellable until a certain period when the lessor has recovered all his investments.

2) Operating Lease

An operating lease is a type of lease in which the lessor does not transfer all rewards and risks to the lessee, which means that the lessee does not take full ownership of the asset. An operating lease lasts for a term that is much less than the economic life of the asset. The lessor does not recover all his investments during this primary period.

Features of a Financial Lease

Based on the above description of a financial lease, the following features can be derived:

  • A finance lease is a device that gives the lessee a right to use an asset.
  • The lease rental charged by the lessor during the primary period of lease is sufficient to recover his/her investment.
  • The lease rental for the secondary period is much smaller. This is often known as peppercorn rental.
  • Lessee is responsible for the maintenance of asset.
  • No asset-based risk and rewards is taken by lessor.
  • Such type of lease is non-cancellable; the investment of the lessor is assured.

Features of an Operating Lease

The features of an operating lease are listed below:

  • The lease term is much lower than the economic life of the asset
  • The lessee has the right to terminate the lease through a short notice and no penalty is charged for that
  • The lessor provides technical knowhow of the leased asset to the lessee.
  • Risks and rewards incidental to the ownership of the asset are borne by the lessor.
  • Lessor has to depend on leasing of an asset to different lessee for recovery of his/or her investment.

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