1. Capital Lease:
This is also called ‘financial lease’. A capital lease is a long-term arrangement which is non-cancelable. The lessee is obligated to pay lease rent till the expiry of lease period. The period of lease agreement generally corresponds to the useful life of the asset concern.
A long-term lease in which the lessee must record the leased item as an asset on his/her balance sheet and record the present value of the lease payments as debt. Additionally, the lessor must record the lease as a sale on his/her own balance sheet. A capital lease may last for several years and is not canceable. It is treated as a sale for tax purposes.
2. Operating Lease:
Contrary to capital lease, the period of operating lease is shorter and it is often cancealable at the option of lessee with prior notice. Hence, operating lease is also called as an ‘Open end Lease Arrangement.’ The lease term is shorter than the economic life of the asset. Thus, the lessor does not recover its investment during the first lease period. Some of the examples of operating lease are leasing of copying machines, certain computer hardware, world processors, automobiles, etc.
There is some criticism too labeled against capital leasing and operating leasing. Let us give the arguments given by the proponents and opponents regarding the two types of equipment leasing. It is argued that a firm knowing about the possible obsolescence of high technology equipment may not want to purchase any equipment. Instead, it will prefer to go for operating lease to avoid the possible risk of obsolescence. There is one difference between an operating lease and capital/financial lease.
Operating lease is short-term and cancelable by the lessee. It is also called as an ‘Open end Lease Agreement’. In case of a financial lease, the risk of equipment obsolescence is shifted to the lessee rather than on the lessor.
The reason is that it is a long-term and non-cancelable agreement or contract. Hence, lessee is required to make rental payments even after obsolescence of equipment. On the other hand, it is said that in operating lease, the risk of loss shifts from lessee to lessor.
This reasoning is not correct because if the lessor is concerned about the possible obsolescence, he will certainly compensate for this risk by charging higher lease rentals. As a matter of fact, it is more or less a ‘war of wits’ only.
3. Sale and Leaseback:
It is a sub-part of finance lease. Under a sale and leaseback arrangement, a firm sells an asset to another party who in turn leases it back to the firm. The asset is usually sold at the market value on the day. The firm, thus, receives the sales price in cash, on the one hand, and economic use of the asset sold, on the other.
Yes, the firm is obliged to make periodic rental payments to the lessor. Sale and leaseback arrangement is beneficial for both lessor and lessee. While the former gets tax benefits due to depreciation, the latter has immediate cash inflow which improves his liquidity position.
In fact, such arrangement is popular with companies facing short-term liquidity crisis. However, under this arrangement, the assets are not physically exchanged but it all happens in records only.
This is nothing but a paper transaction. Sale and lease back transaction is suitable for those assets, which are not subjected to depreciation but appreciation, say for example, land.
4. Leveraged Leasing:
A special form of leasing has become very popular in recent years. This is known as Leveraged Leasing. This is popular in the financing of “big-tickets” assets such as aircraft, oil rigs and railway equipments. In contrast to earlier mentioned three types of leasing, three parties are involved in case of leveraged lease arrangement – Lessee, Lessor and the lender.