Leasing is an ancient method of financing that is now gaining popularity almost all over the world. Legally, the lease is not a sale of the object, but a sale of the usufruct (the right to use the object) for a specified period of time. According to him, there are two parties, one is the owner or lessor of the asset and the other is the lessee or the party that takes the asset under lease. The lessee takes the asset for use for a specified period of time and makes rental payments. Ownership of the asset rests with the lessor, but it is in the possession of the lessee and the right of use is also transferred to the lessee.
It has following are different types. The two basic types of leasing are: finance lease and operating lease. These are explained below:
(1) Finance lease: Under a finance lease, all risks and rewards inherent in ownership of the asset are transferred to the lessee. Ownership or title may or may not be transferred. A finance lease is something like an installment purchase agreement. Under a finance lease, the lessee, after paying the agreed number of installments, has the right to exercise an option to become the owner of the asset.
Example:
Suppose that company AB rents a new car for three years. Suppose also that after three years company AB will be called to take ownership of the vehicle at no additional cost. In this case, not only is the vehicle rented, but also the AB company uses the lease as a means of financing the car. This type is called a finance lease or finance lease.
(2) Operating lease: According to the International Accounting Standard (IAS-17), an operating lease is one that is not a finance lease. In an operating lease, the lessor grants the lessee the right to use the asset or property for a specified period of time, but the risks and rewards of the property are retained by the lessor.
Example:
Suppose MY companies owns a full sixth floor in Eden Tower, a multi-story building. Suppose further that MY companies lease some rooms on this floor to corporation XY.
However, if the value of this building increases due to a good commercial activity, the landlord, that is, MY companies, can benefit from this increase by selling the rooms or increasing the amount of the rent. On the other hand, if the value of the building decreases, MY companies will also suffer losses. This type of lease is called an operating lease.
In addition to these two main types, some other types of leases are explained below:
(3) Sale and subsequent lease: Under a sale and leaseback agreement, an asset is first sold to the financial institution. The sale is made at the real market value. After that, the asset is recovered under lease. This type of lease is advantageous for those 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 lease, it simultaneously recognizes it as a liability in the financial statement.
(5) Leveraged lease: This type of lease consists of three parts that include a lender, a landlord, and a tenant. The lender and the lessor come together to accumulate funds to purchase the asset. The purchased asset is delivered in the lease to the lessee. The lessee makes periodic payments to the lessor, who in turn makes the payment to the lender.
(6) Cross-border leasing: It means operating a lease in other countries. This type of leasing is very difficult in the current circumstances. The reasons are that different accounting treatments, tax burdens and incidental criteria prevail abroad. Also, tax rules differ from country to country. Then a big problem arises about how to present such a lease in the financial statement.
However, as with recent developments, accounting treatments are being made similar for each item around the world by International Accounting Standards and cross-border leasing is expected to flourish rapidly in the near future.