What Lease Types Are There?
If you are a business that’s looking at using leasing as a method to finance your assets, you are bound to feel the impact of the upcoming implementation of IFRS 16.
When you take into account the sheer size of the task at hand, having to prepare for the new lease accounting standards is going to be a tough ask for most businesses.
However, before you can even begin to prepare for changes that are coming into effect on January 1, 2019, it’s important to understand the kinds of leases and lease types there are, ranging from finance leases to operating leases.
There’s been lots of coverage about how the lease accounting changes may be a negative for businesses who have an extensive lease portfolio. But, with proper preparation, there’s a chance to still use leasing to grow your business. So, don’t be perturbed.
First, it’s important to know what a lease actually is. It’s where one party, called the lessor, provides an asset for the other party, called the lessee, against periodic payments for a specified time period. Accounting for leases depends on the terms and conditions of the lease, and the types of leases include:
- Finance Lease
- Operating Lease
- Capital Lease
- Property/Real Estate Lease
- Sale and Leaseback
A finance lease is quite self-explanatory. It’s a way of providing finance where a leasing company purchases the item in question for the lessee and rents it to them for a time period they’ve agreed on. The lessee may be offered the continued use of the equipment at lease end for a “peppercorn” rental providing all primary rentals have been paid in accordance with the agreement
One of the most popular items released that falls into this bracket is car leasing, where the deal is often a long-term lease where the lessee will pay a fixed monthly fee to use the car for a set amount of time, and for a certain number of miles.
A finance lease isn’t just limited to a vehicle, as the lessor can charge a rent as their reward for hiring any asset to the lessee, whether it’s a car, construction equipment or even a laptop, for example.
The lessor will retain ownership of the item, but the lessee gets exclusive use of the asset and will continue to make rental payments that cover the original cost of the asset during the initial period of the lease.
There is also an obligation to pay all of these rentals, which can also include a balloon payment at the end of a lease contract, so once these have all been paid the lessor will have recovered its investment in the item or asset.
A finance lease means the lessee is committed to paying the fees over the agreed time period, and while it may be possible to terminate early, the lease is often defined as non-cancellable.
For example, if you did want to terminate your car lease early, you would have to pay an agreed fee for the remainder of the lease agreement. Once the primary finance lease period is over, depending on the agreement, there are several options to see how the agreement continues. The lessee could sell the asset to a third party, acting on behalf of the lessor, the asset could also be returned to the lessor to be sold, or the customer could even enter into a second lease period with the lessor.
The benefit to lessee businesses who use finance lease agreements is that they get immediate use of an asset without spending the capital in one costly transaction. It’s beneficial to cash flow management.
As opposed to a finance lease, an operating lease does not transfer substantially all of the risks and rewards of ownership to the lessee. This lease generally runs for less than the full economic life of the asset and the lessor would expect the item to have a resale value once the lease period has come to an end - this is referred to as the residual value.
The residual value is forecast at the beginning of the lease period, where the lessor takes the risk that the asset will achieve this value or not when the lease contract expires. Residual values are typically found in operating leases, as the sort of assets that fall into this category include aircrafts, vehicles and construction plant and machinery. The lessee gets the use of the asset over the agreed lease period in return for regular rental payments, but these payments don’t cover the full cost of the asset, as is the case with financial leasing.
Ownership of the asset then remains with the lessor and the item will either be returned at the end of the lease period, or the lessee can continue to rent the item at a fair market rent which would be agreed at the time.
The benefit to both parties is that, if the asset is still in a suitable condition, continued use at a now fairer rate is easily agreeable. This stops the lessee having to shop around for a new agreement and removes the burden of having a stagnant asset on the books for the lessor.
A capital lease is a lease agreement in which the lessor agrees to make available the transfer of the ownership rights of an item, equipment or product to the lessee, once the lease period and payments that had been agreed upon have been completed. A capital lease, like a finance lease, is long-term and is non-cancellable in nature.
The lease agreement gives the lessee a bargain option by dint of which the lessee can purchase the asset at a discounted price, rather than paying the fair market value once the lease term has come to an end.
Property/Real Estate Lease
A property or real estate lease is an agreement between you and your landlord allowing you to use the premises. The lease is usually in writing and covers the space occupied, the rent, the length of the lease as well as your obligations and rights and those of your landlord. A property lease covers areas such as the rent, and how much it could increase over the length of the lease, as well as any other clauses.
For example, if you lease a property and you hit financial difficulties, the lease will cover whether your landlord will agree to let you give up the lease before the expiry date, or whether they would let you transfer the premises to someone else. Property and real estate leases can also be broken into much smaller leasing sections, such as gross, full-service, net and percentage.
Sale and Leaseback
Sale and leaseback is used to describe an arrangement where the owner sells an asset or item of theirs for an agreed sum and takes back a lease on it, either at a rack rent (which could be full open market rent or the maximum permitted by law) or at some other rent related to price-paid for a fixed period of time. Essentially, the seller of the asset becomes the lessee and the purchaser becomes the lessor in this arrangement.
Sale and leaseback arrangements are often used in both residential and commercial sectors, and it allows sellers to raise capital, which can then be used to invest in its business. For example, supermarkets will use their property portfolios to enter into sale and leaseback arrangements to that they can raise capital to invest in their business activities, while still being able to continue occupying the premises.
With so many varying types of leases, it’s likely that you will find some types of agreement suitable to your financial goals and circumstance. It’s even more important to be prepared for the impending changes that IFRS 16 is going to bring.
Decide How To Manage Your Lease Portfolio Following IFRS 16
The level of work that needs to go into assessing the impact of IFRS 16 is tough, but there are tools that can help in the future and make the process much easier. Before you think about lease management beyond 2019, it’s more crucial to prepare for achieving compliance as soon as possible.
Take a look at this free seven-step guide to help achieve compliance: