Lease is the contractual agreement between two parties, in which one party usually the owner of Tangible or intangible Asset allows use of this asset to second party against periodic payment of lease rentals. The one who owns this asset is called “lessor” and the one who is using this asset by paying periodic rental payment is called “ lessee”. Tangible Assets in lease agreement involve, Equipments, vehicles, land etc. Intangible Assets includes computer program/software, license of any service.
Typically, there are two method of lease agreement, we also called types of lease : Operating lease and Finance lease/Capital lease.
Operating Lease, in this lease agreement, lessor allow use of Tangible or intangible assets, for shorter period. Lease rentals are paid on periodic basis which lessee charges in to profit and loss as “expense”. Lessor recognizes these rental payments received from lessee as “income”. No ownership is transferred to lessee at the end of lease agreement. This lease arrangement is usual for companies, which have custom of replacing equipment frequently so they do not buy equipment and go for lease agreement for a defined period, normally few months or years and this duration is less than the useful life of asset hired under lease agreement. After completion of lease period, this asset is returned to lessor , which has a resale value at that point. During the period of operating lease, lessor has the obligation to repair and maintain the asset when necessary. No amortization is charged in financial statement against operating lease.
Finance/Capital Lease: As the word capital shows, this lease agreement is for longer period usually approximately equals to the useful life of asset, after which ownership of the asset will be transfer to lessee. Lessee will make the lease rentals on periodic basis, whose NPV will be equal to 90% of the cost of asset. Lessee will record two entries in Accounts; Asset will be record at cost less accumulated depreciation, lease rentals will be record as Liability. The substance of this lease agreement is “asset purchase”. In operation lease, asset is hired but in finance lease asset is purchased at the end of Lease period. Normally, this type of lease occurs when asset under lease has no resale value and lessor is not going to sale it further. During the period of finance lease, it is the responsibility of lessee to maintain the asset when necessary. Amortization is made yearly and recorded in books of accounts.
Operating lease is in true sense hiring agreement and finance lease is an purchase agreement. Which one is the better? this answer has many aspects to consider.
If the use of any asset is required for certain period of time, hiring the asset would be a better idea with respect of financial outflow. On the other hand, if you are relying on this asset for your yearly trade and find no better alternative, then going for purchase agreement is a better solution. In lease agreement, the responsibility and cost of maintenance is towards lessor , in order to save yourself from running for maintenance and insurance, go for the operating lease.