Finance lease and Operating lease

Finance lease and Operating leaseBPT

What is the difference between Finance lease and Operating lease?Even though the lessor is the rightful owner of the asset and most often owners are responsible to bear any loss and obtain economic benefits associated with the asset but sometimes the risks and rewards associated with the assets are transferred to another person by the owner himself without transferring the title of ownership of the asset. Same is the case with the finance lease.RememberIn simplest words,transfer of risks and rewardsMEANStransfer ofcontrolof the asset. And from the definition and recognition principle of the asset we understood that it is the control of the asset that is important and not the ownership of the asset that determines the rightful person to report the asset in his books of account.And from this we can understand that underfinance leasethe risks and rewards (control) of the asset are transferred to lessee therefore, lessee will write the asset in his books even though he is not the owner.But underoperating leaserisks and rewards (control) of the asset areNOTtransferred therefore, the lessor, who is the owner of the asset, will write the asset in his books of accounting.What is risk?Risk is simple the risk of bearing the losses connected with the asset or lease agreement. For example the person who is responsible for the following losses or expenses is the person who is bearing the risks: person responsible for upkeep of asset i.e. repairs or person responsible for securing the asset i.e. insurance premium or the person who will bear the loss in case asset is stolen possible losses from idle capacity devaluation in asset because of technological obsolescence fluctuations in returns because of changing economic conditions

What is reward?Reward simply means economic benefits that can be rendered from the asset. For example the person who is responsible for the following benefits is person enjoying the benefits from the assets: earning revenue profitably by selling goods produced, constructed by using the asset earning rental income by letting or sub-letting the asset appreciation in the value of asset (revaluation gain) appreciation in the residual value (sales value) of assetSUBSTANTIAL Risks and Rewards INCIDENTAL to OWNERSHIP!Substantial meanssignificantor in other wordsalmost all of them. Incidental to ownership means something that isprimarily associated with the ownership. So we understood that almost all of such kinds of risks and rewards that primarily resulted from the ownership of the asset must be transferred to constitute atransfer of control.And it is the control that determines the type of lease agreement.Care must be exercised in categorizing the risks and rewards as connected with the ownership. Not every reward and risk is incidental to ownership. There are only few risks and rewards which determines the control of the asset and if substantial amount of those risks and rewards is transferred only then a lease will be treated as finance lease. For example, a lessee may earn revenue by using the asset but he may not have the right to recognize revaluation gain of the asset.

Hire purchase (HP) or leasing

Hire purchase (HP) or leasing is a type of asset finance that allow firms or individuals to possess and control an asset during an agreed term, while paying RENT or INSTALLMENTS covering depreciation of the asset, and interest to cover capital cost.

Assets are defined as anything of monetary value that is owned by a firm or an individual. Assets listed on a firms balance sheet can include tangible items such as inventories, equipment and real estate, as well as intangible items such as property rights or goodwill.

Leases differ from term lending in that the lessee does not have ownership rights to the asset. At the end of the lease contract, the lessee usually has a choice of extending the lease, returning the asset, or introducing a buyer for the asset. Some leasers are entitled to a refund of 95% of the sale proceeds when they introduce a buyer. The refund amount will depend on the contract between the original leaser and lessee.

HP is a financing solution suitable for businesses wishing to purchase assets without paying the full value immediately. The customer pays an initial deposit, with the remainder of the balance and interest paid over a period of time. On completion, ownership of the asset transfers to the customer.

It is important to note that the accounting and tax treatment of leases varies according to the type of lease it is. For example, as a finance lease is accounted for as a loan funding the asset, the tax treatment follows the legal form of the transaction which is the hiring of an asset. More specifically, the treatment of capital allowances differs, and tax treatment should be taken into consideration when deciding how to finance an asset purchase.

Common use

The use of HP or leasing is particularly common in industries where expensive machinery is required, such as construction, manufacturing, plant hire, printing, road freight, transport, engineering and professional services.

It is also used to finance other capital requirements of a business for example: smaller items cars photocopiers.The asset provider usually dictates this type of linked finance.CostsThere are two main costs that need to be considered: interest rate charged for financing. Rates are favourable to assets with higher resale value (ie machinery, agricultural equipment, vehicles etc). Assets that are considered soft due to their low resale value (ie printers, vending machines, office furniture etc), will be given less favourable rates fees charged by the financing company for loan processing and administrative workmeeting conditions. For example, a car purchased on HP may need servicing at regular intervals and from a pre-approved workshop.

TimeframeAn HP or leasing facility can normally take up to a week to complete, depending on the size and complexity of the deal.Advantages HP or leasing allows companies to control and deploy assets without significant drain on working capital fixed-rate funding makes budgeting easy as the lessee has clear sight of future expenditures flexibility of repayment structuring is available to allow for seasonal business (eg one repayment a year), and to reduce monthly outlay by factoring in a balloon payment at the end of the term leasing prevents the risk of an assets value depreciating quickly and provides flexibility to enter into a new contract at the end of the original leases fixed term financing asset purchases can be more tax efficient than standard-term loans due to lease payments being booked as expenses. Although asset depreciation also provides tax benefits, the useable lifetime of the asset will vary depending on the asset and on local regulation high accessibility of financing for businesses due to the financing being secured with the leased asset and the asset being owned by the financing company in certain circumstances there is maintenance included within the terms of the agreement.

Disadvantages total sum of capital payments for HP or leasing will be higher than the full payment on the asset purchase administrative complexity and costs will be greater if any covenants are applied to the arrangement. For example, updates on change of equipment locations if the business changes its strategy, resulting in the leased asset no longer being useful, there can be early termination charges or restrictions on subleasing.

Other optionsTheright finance for your businesssection of the site gives examples of financial structures that are suitable for different trading types and sizes of business.HP or leasing is a medium- to long-term solution to support the use of an asset for a certain period of time. An alternative is abank loan, which allows firms to purchase an asset and have immediate ownership of it.

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