Lease financing is one of the important sources of medium- and long-term financing where the owner of an asset gives another person, the right to use that asset against periodical payments. The owner of the asset is known as lessor and the user is called the lessee.
The periodical payment made by the lessee to the lessor is known as lease rental. Under lease financing, the lessee is given the right to use the asset but the ownership lies with the lessor and at the end of the lease contract, the asset is returned to the lessor or an option is given to the lessee either to purchase the asset or to renew the lease agreement.
Two Types of Lease:-
Depending upon the transfer of risk and rewards to the lessee, the period of the lease and the number of parties to the transaction, lease financing can be classified into two categories.
a) Finance Lease
b) Operating Lease.
a.) Finance Lease:
It is the lease where the lessor transfers substantially all the risks and rewards of ownership of assets to the lessee for lease rentals. In other words, it puts the lessee in the same condition as he/she would have been if he/she had purchased the asset. The finance lease has two phases: The first one is called a primary period. This is a non-cancellable period and in this period, the lessor recovers his total investment through lease rental. The primary period may last for an indefinite period of time. The lease rental for the second period is much smaller than that of the primary period.
b.) Operating Lease:
A lease other than a finance lease is called an operating lease. Here risks and rewards incidental to the ownership of the asset are not transferred by the lessor to the lessee. The term of such lease is much less than the economic life of the asset and thus the total investment of the lessor is not recovered through lease rental during the primary period of the lease. In the case of an operating lease, the lessor usually provides advice to the lessee for repair, maintenance and technical know-how of the leased asset and that is why this type of lease is also known as service lease.